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Economic
Development
Reading: Todaro Chapter 3
Classic Theories of Economic
Development
1
© Natalya Brown 2008
QUOTES OF THE DAY
It matters little how much information we
possess about development if we have not
grasped its inner meaning.
(Denis Goulet. The Cruel Choice)
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QUOTES OF THE DAY
Development must be redefined as an attack
on the chief evils of the world today:
malnutrition,
disease,
illiteracy,
slums,
unemployment and inequality. Measured in
terms of aggregate growth rates, development
has been a great success. But measured in
terms of jobs, justice and the elimination of
poverty, it has been a failure or only a partial
success.
(Paul P. Streeten, Former Director, World Development Institute)
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Part I
• Four Major Strands of Thoughts:
 Often competing development theories, all
trying to explain how and why development
does or does not occur.
• Newer models, an eclectic approach, often draw
on various aspects of these four classic theories.
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Four Approaches
1) Linear-Stages-of-Growth Models
2) Structural-Change Models
3) International-Dependence Revolution
4) Market Fundamentalism
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1). Linear-Stages-of-Growth Models
• Popular in the 1950’s and 1960’s
• The process of development as a series of successive
stages.
• Economic theory, right quantity and mixture of saving,
saving and foreign aid, along an economic growth path
that had been followed by MDCs.
• Synonymous with rapid, aggregate economic growth
• Replaced in the 1970’s by Structural Change and
International Dependence models.
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2). Structural change models
• Used modern economic theory and
statistical analysis
• Emphasizing the internal process of
structural change that a “typical” DC must
go through
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3). International dependence models
• viewed underdevelopment in terms of
international and domestic power
relationships, institutional and structural
rigidities and
• the resulting proliferation of dual economies
and dual societies both within and among
nations of the world.
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4). Market Fundamentalism
• In the 1980’s and 1990’s the neoclassical
counterrevolution focused on the beneficial
role of free markets, open economies and the
privatization of public enterprises
• suggested that the failure of some economies
to develop is a result of too much government
intervention and regulation.
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1. Linear-Stages-of-Growth Models
• The LDCs could learn a lot from the historical growth
experience of the now MDCs in transforming their
economies from poor agrarian societies to modern
industrial giants.
• Emphasized the role of accelerated capital
accumulation.
•
Rostow’s Stages of Growth and Harrod-Domar’s
Growth Model
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1.1 Rostow’s Stages of Growth
•
Economic development can be described in terms of a
series of steps through which all countries must
proceed:
1. The Traditional Society
2. The Pre-conditions for take-off into self-sustaining
growth
3. The Take-off
4. The Drive to Maturity
5. The Age of High Mass Consumption
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Rostow’s Stages of Growth
•
Advanced nations were considered well
beyond the take-off stage while
underdeveloped nations were seen as still
in the traditional or pre-conditions stages.
•
Emphasized the need for the mobilization
of domestic and foreign investment in order
to accelerate growth.
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It also denies Friedrich List’s argument that countries
reliant on exporting raw materials may get “locked
in”, and be unable to diversify, in that Rostow’s model
states that countries may need to depend on a few
raw material exports to finance the development of
manufacturing sectors which are not yet of superior
competitiveness in the early stages of take-off. In that
way, Rostow’s model does not deny John Maynard
Keynes in that it allows for a degree of government
control over domestic development not generally
accepted by some ardent free trade advocates.
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As a basic assumption, Rostow believes that
countries want to modernize as he describes
modernization, and that the society will ascent to
the materialistic norms of economic growth.
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1. Traditional Societies
Traditional societies are marked by their preNewtonian understanding and use of technology.
These are societies which have pre-scientific
understandings of gadgets, and believe that gods
or spirits facilitate the procurement of goods,
rather than man and his own ingenuity. The
norms of economic growth are completely absent
from these societies.
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2. Preconditions for Take-off
• The preconditions to take-off are, to
Rostow, that the society begins committing
itself to secular education, that it enables a
degree of capital mobilization, especially
through the establishment of banks and
currency, that an entrepreneurial class
form, and that the secular concept of
manufacturing develops, with only a few
sectors developing at this point. This leads
to a take off in ten to fifty years.
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3. The Take-off
• Take-off then occurs when sector led
growth becomes common and society is
driven more by economic processes than
traditions. At this point, the norms of
economic growth are well established.
• Transition from traditional to modern
economy
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4. The Drive to Maturity
• The drive to maturity refers to the need for
the economy itself to diversify. The sectors
of the economy which lead initially begin to
level off, while other sectors begin to take
off. This diversity leads to greatly reduced
rates of poverty and rising standards of
living, as the society no longer needs to
sacrifice its comfort in order to strengthen
certain sectors.
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5. Age of High Mass Consumption
• The age of high mass consumption refers to the
period of contemporary comfort afforded many
western nations, wherein consumers
concentrate on durable goods, and hardly
remember the subsistence concerns of previous
stages.
• in the age of high mass consumption, a society
is able to choose between concentrating on
military and security issues, on equality and
welfare issues, or on developing great luxuries
for its upper class.
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Criticism
• Strong bias towards western model of
modernization (free vs. controlled markets,
China).
• Tries to fit economic progress into a linear
system (many countries make false starts,
Russia).
• It considers mostly large countries: countries
with a large population (Japan), with natural
resources available at just the right time in its
history (Coal in Northern European countries), or
with a large land mass (Argentina).
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1.2 Harrod-Domar Growth Model
(AK Model)
• Following on Rostow’s theory the AK model
describes the mechanism by which more
investment leads to more growth.
• Pointed to the necessity of net additions to the
capital stock
• Used to explain an economy's growth rate in
terms of the level of saving and productivity of
capital.
• It suggests there is no natural reason for an
economy to have balanced growth.
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Concepts of Growth
• Warranted growth – the rate of output growth at
which firms believe they have the correct amount
of capital and therefore do not increase or
decrease investment, given expectations of future
demand.
• Natural rate of growth – The rate at which the
labour force expands, a larger labour force
generally means a larger aggregate output.
• Actual growth – The actual aggregate output
change.
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Concepts of Growth
• There is no guarantee that an economy will
achieve sufficient output growth to sustain full
employment in a context of population growth.
• The problem arises when actual growth either
exceeds or fails to meet warranted growth
expectations. A vicious cycle can be created
where the difference is exaggerated by attempts
to meet the actual demand, causing economic
instability.
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Components
– Capital stock (K)
– Output (Y) = GDP
– Capital-Output ratio (k): the dollar amount of
capital needed to produce a $1 stream of
GDP.
K/Y or ΔK/ΔY
– Savings (S) and the savings ratio (s): the fixed
proportion of national output that is used for
new investment.
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K  I  K
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So
S = sY
(1)
• Net investment is the change in the capital stock
I = ΔK
(2)
• Remember that k = K/Y or ΔK/ΔY, so that
ΔK = kΔY
(3)
• Net savings must equal to net investment so that
S = I. Combining (1), (2) and (3):
sY = kΔY
s/k = ΔY/Y
ΔY/Y is the growth rate of GDP.
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• Increasing the savings rate, increasing
the marginal product of capital, or
decreasing the depreciation rate will
increase the growth rate of output;
• So the growth rate of GDP is
determined jointly by the savings ratio, s,
and the national capital-output ratio
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• So the rate of growth of GDP is positively related
to the economies savings ratio and negatively
related to the economies capital-output ratio.
• The more economies save and invest, the faster
they can grow but the actual rate of growth is
measured by the inverse of the capital-output
ratio – the output-capital ratio.
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• The fact that LDCs savings levels are often not
enough to meet the levels suggested by the
linear-stages models, the need to fill the
“savings gap” was used to justify massive
transfers of capital and technical assistance from
developed countries to LDCs.
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• More savings and investment is not a sufficient
condition for accelerated rates of economic
growth. Many LDCs lack the necessary structural,
institutional and attitudinal conditions to convert
new capital effectively into higher levels of output.
They also lacked the complementary factors of
production (e.g. skilled labour and managerial
competence).
• Also the development strategies proposed by the
stages models failed to take into account the
global environment in which developing countries
exist – one in which development strategies can
be thwarted by external forces beyond the
countries control.
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• The main criticism of the model is the level of
assumption, one being that there is no reason
for growth to be enough to maintain full
employment, this is based on the belief that the
relative price of labour and capital is fixed, and
that they are used in equal proportions. The
model explains economic boom and bust by the
assumption that investors are only influenced by
output (known as the accelerator principle), this
is now widely believed to be false.
• Sees economic growth and development as the
same, in reality, economic growth is only a part
of development.
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• Sees economic growth and development
as the same, in reality, economic growth
is only a part of development.
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2. Structural Change Models
2.1
2.2
Lewis Two-Sector Model
Patterns-of-Development Approach
• These models tend to emphasize the
transformation of domestic economic structures
from traditional subsistence agriculture
economies to more modern, urbanized and
industrially diverse manufacturing and service
economies.
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2.1 Lewis Two-Sector Model
• The economy consists of two sectors:
– The traditional agricultural sector is typically
characterized by low wages, an abundance of
labour, and low productivity through a labour
intensive production process.
– the modern manufacturing sector is defined by
higher wage rates than the agricultural sector,
higher marginal productivity, and a demand for
more workers initially
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2.1 Lewis Two-Sector Model
• Labour can be withdrawn from the traditional
sector without any loss of output
• Focus is on labour transfer and output and
employment growth in the modern sector. The
rate at which this occurs is determined by the
rate of industrial investment and capital
accumulation in the modern sector.
• Wages in the industrial sector are fixed at a
premium above wages in the traditional sector. It
is assumed that rural labour supply is perfectly
elastic.
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• Lewis assumed that with the urban wage above the
average rural wage, that the modern-sector
employers could hire as many surplus rural workers
as the wanted without fear of rising wages
•The successive reinvestment of profits from the
modern sector would increase the production
possibilities of that sector leading to successive
increases in the demand for labour. The employment
expansion in the industrial sector would continue until
all the excess labour from the traditional sector is
absorbed. From that point onwards, modern sector
wages would rise in order for industrial employers to
attract additional workers from the traditional sector.
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•Improvement in the marginal productivity of labour in the
agricultural sector is assumed to be a low priority as the
hypothetical developing nation's investment is going towards
the physical capital stock in the manufacturing sector.
• Over time as this transition continues to take place and
investment results in increases in the capital stock, the
marginal productivity of workers in the manufacturing will be
driven up by capital formation and driven down by additional
workers entering the manufacturing sector. Eventually, the
wage rates of the agricultural and manufacturing sectors will
equalize as workers leave the agriculture for the
manufacturing, increasing marginal productivity and wages in
the agriculture while driving down productivity and wages in
manufacturing.
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• The end result of this transition process is that the
agricultural wage equals the manufacturing wage,
the agricultural marginal product of labour equals
the manufacturing marginal product of labour, and
no further manufacturing sector enlargement takes
place as workers no longer have a monetary
incentive to transition.
• One of the problems with Lewis’ model is that it
assumes that the rate of labour transfer and
employment creation is proportional to the rate of
modern sector capital accumulation. It does not
leave room for the possibility that capitalist profits
could be reinvested in labour-saving capital
equipment nor does it leave room for the possibility
of capital flight.
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• The model also assumes surplus labour in rural
areas and full employment in urban areas. By and
large this is not the case in most developing
nations.
•The assumption of a competitive modern-sector
labour market that allows modern sector wages to
remain fixed until the rural sector labour surplus is
exhausted is unrealistic. In reality there is a
tendency for urban wages to rise over time, even
when there is considerable urban unemployment.
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2.2. Patterns-of-Development Approach
• Focus on the sequential process through which
the economic, industrial, and institutional
structure of an underdeveloped economy is
transformed over time to permit new industries to
replace traditional agriculture as the engine of
economic growth.
• In contrast to the Lewis model and the original
stages view of development, increased savings
and investment are perceived as necessary but
not sufficient conditions for economic growth.
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2.2. Patterns-of-Development Approach
• Along with accumulation of human and physical capital,
a set of interrelated structural changes are needed to
make the transition from traditional economy to a
modern one.
• Structural changes:
– Transformation of production and changes in the
composition of consumer demand
– International trade
– Resource use
– Changes in socioeconomic factors such as
urbanization and the growth and distribution of the
population
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• Both domestic and international constraints on
development are emphasized.
 Domestic constraints:
economic constraints (country’s resource endowment and
physical and population size), and institutional constraints
(government policies and objectives).
 International constraints:
Access to external capital, technology and international
trade.
• The extent to which countries face these constraints
determines their development level.
• The importance of the integrated international system
in which developing countries belong – a system that
can promote or hinder their development.
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• Based on extensive empirical work conducted by
Hollis B. Chenery and his colleagues identified
several characteristic features of the development
process:
– The shift from agricultural to industrial production
– The steady accumulation of physical and human
capital
– The shift in consumer demands from basic
necessities to desires for diverse manufactured goods
and services.
– The growth of cities and urban industries as people
migrate from farms and small towns
– The decline in family size and overall population
growth
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CONCLUSIONS
 The main hypothesis of structural change
models is that development is an identifiable
process of growth and change whose main
features are similar in all countries.
 However recognition is given to the differences
in the circumstances of developing countries
such as differences in physical endowments.
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CONCLUSIONS
 Practitioners of this approach may be lead to
draw incorrect conclusions about causality since
the approach is based on empirical observation
and less on theory.
For example, practitioners may observed the important
role of higher education in developed countries and
recommend policies to develop an advanced university
system even before the majority of the population has
gained basic literacy. This policy could backfire by
leading to an increase in inequality.
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CONCLUSIONS
 Often the patterns identified through empirical
observation point to international factors that
are largely out of the control of individual
countries.
 Structural change analysts are optimistic
because they believe that the right mix of
economic policies will generate beneficial
patterns of self-sustaining growth
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3. International-Dependence Revolution
3.1
3.2
3.3
Neocolonial Dependence Model
False-Paradigm Model
Dualistic-Development Thesis
Grew out of the increasing disenchantment with both the
stages-of-growth and structural-change models.
Went out of favor in the 80’s and 90’s, its versions enjoyed
resurgence in the early years of 21th century.
These models view developing countries as beset by
institutional, political, and economic rigidities both domestic
and international, and caught up in a dependence and
dominance relationship with rich countries.
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3.1 Neocolonial Dependence Model
• Indirect outgrowth of Marxist thinking, laying the
blame for the existence of underdevelopment on
the shoulders of the historical evolution of a
highly unequal capitalist system of rich countrypoor country relationships.
• The dominance of the unequal power
relationships between the center (the rich
countries) and the periphery (the developing
countries) renders the attempts by the LDCs to
be self-sufficient and independent difficult.
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3.1 Neocolonial Dependence Model
• Also the members of the small elite ruling class in the DCs
has principal interests, knowingly or not, that help to
perpetuate the international capitalist system of inequality
and conformity.
• Directly and indirectly the elite class serve and are
rewarded by international special-interest power groups
(e.g. multi-national corporations, multilateral assistance
organizations like the IMF), which are tied by the
allegiance or funding to the wealthy capitalist countries.
•
Often, elite activities tend to hinder any reform efforts that
might benefit the population at large leading to perpetual
underdevelopment.
49
• The continuing poverty in the developing world is
largely attributed to the existence and policies of the
industrial capitalist countries and their extensions in
the form of small but powerful elite groups in LDCs.
• Underdevelopment is seen as an externally-induced
phenomenon. Dependent countries can only expand
as a reflection of the expansion of the dominant
countries. Dependence causes the dependent nations
to be both backward and exploited.
• Revolutionary struggles or at least the restructuring of
the world capitalist system are therefore required.
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3.2 The False-Paradigm Model
• Less radical than international dependence models,
these models attribute underdevelopment to faulty
and inappropriate advice provided by well-meaning
but often uninformed, biased and ethnocentric
international advisers from developed-country
assistance agencies and multinational donor
organizations.
• The advice given fails to recognize resilient traditional
social structures, the highly unequal ownership of
land and other property rights, the disproportionate
control of elites over domestic and international
financial assets and the very unequal access to
credit.
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3.2 The False-Paradigm Model
.
• The policy advice generated from classical and neoclassical models in many cases merely serve to protect the
interests of the existing power groups, both domestic and
international.
• Also local university intellectuals, high-government officials
and other civil servants receive training in developedcountry institutions where they learn ‘irrelevant’ theoretical
models.
•
Too much ‘technoratic’ measures, e.g. ICOR, investment
ratios, privatization and deregulation, neglecting desirable
institutional and structural reforms
52
3.3 Dualistic Development Thesis
•
•
A world of dual societies, the existence and
persistence of increasing divergences between rich
and poor nations, and in the DCs, pockets of wealth
within broad areas of poverty.
Four elements of dualism:
1. Different sets of conditions, of which some are superior
and others inferior, can coexist in a given space.
2. The coexistence is chronic and not transitional.
3. The degrees of superiority or inferiority have a tendency
to increase over time.
4. The superior element does little or nothing to pull up the
inferior element and may in fact serve to push it down.
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TWO MAJOR WEAKNESSES OF DEPENDENCE
THEORIES
•
•
Offer little formal or informal explanation of how
countries initiate and sustain development
Actual economic experience of LDCs having pursued
revolutionary campaigns on industrial nationalization and
state-run production has been mostly negative.
Dependency theory suggests that countries should become
more inward-looking and less entangled with developed
countries, trading only with other developing countries. India
and Chine pursuing inwardly directed development
experienced stagnant growth and eventually opened up their
economies. The Four Asian Tigers emphasized exporting to
developed countries and have prospered.
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Structural-Change vs. International Dependence
Structural Change
• Emphasis is on traditional
neoclassical theories designed
to generate GDP growth
• Optimistic that the right mix of
economic policies will generate
beneficial patterns of selfsustaining growth
• Underdevelopment is a result of
internal constraints such as
insufficient savings and
investment or lack of education
and skills.
International Dependence
• Emphasis is on international
power imbalances and the need
for fundamental economic,
political and institutional reforms
both domestic and worldwide.
• Pessimistic in that they offer an
appealing explanation of
underdevelopment but they offer
little formal or informal
explanation of how countries can
initiate and sustain development.
• Underdevelopment is an
externally induced phenomenon
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4. The Neoclassical Counterrevolution
4.1. Challenging the Statist Model: Free Markets,
Public Choice and Market-Friendly
Approaches
•
In developed countries: favored supply-side policies,
rational expectation, and privatization
• In developing countries: freer markets and the dismantling
of public ownership, statist planning, and government
regulation of economic activities.
56
•
Neoclassicists also obtained controlling power of the
world’s two most influential international financial agencies
- the World Bank and the International Monetary Fund
(IMF).
• Neoclassical counterrevolution argues that
underdevelopment is the result of poor resource allocation
due to incorrect pricing policies and too much state
intervention by overly-active developing-nation
governments.
• State intervention often slows the pace of economic
growth.
57
• Allowing competitive free markets to flourish, privatizing
state-owned enterprises, promoting free trade and export
expansion, welcoming investment from developed countries
and removing the plethora of government regulations and
price distortions in factor, product and financial markets, will
stimulate both economic efficiency and economic growth.
• Third World is underdeveloped dues to:
heavy hand of the state and corruption, inefficiency, and lack
of economic incentives.
•
Need to promote free markets and laissez-faire economies
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THREE COMPONENT APPROACHES
(i) The Free Market Approach:
 markets alone are efficient
 competition is effective, if not perfect;
technology is freely available and nearly
costless to absorb; information is also perfect
and nearly costless to obtain.
 So government intervention in this context is
distortionary and counterproductive.
59
THREE COMPONENT APPROACHES
(ii) Public-choice theory or new political economy
approach:
Government can do nothing right. Politicians,
bureaucrats, citizens and states are all selfinterested and take action to achieve their own
ends. Minimal government is the best
government.
60
THREE COMPONENT APPROACHES
(iii)
Market-friendly Approach:
Recognizes the imperfections in LDC product
and factor markets and recognizes the need for
government to facilitate the operation of markets
through market-friendly interventions. Also
recognizes that marker-failures are more
prominent in developing countries.
61
4.1. Traditional Neoclassical Growth Theory
• Traditional neoclassical models of growth are a
direct outgrowth of the Harrod-Domar and Solow
models, which both stress the importance of
savings.
• The Solow Model expanded on the Harrod-Domar
formulation by adding a second factor of production
– labour – and by introducing a third independent
variable – technology – to the growth equation.
62
Solow Model
• Exhibits diminishing returns to labor and
capital separately and constant returns to
both factors jointly.
• Technological progress became the
residual factor explaining long-term
growth. The level of technological
progress was assumed to be exogenous.

1
Y  K (AL)
Y is GDP, K is the capital stock, L is labour and A represents the
productivity of labour which grows at an exogenous rate.
63
• According to traditional neoclassical growth
theory, output growth results from
– Increases in labour quantity and quality
– Increases in capital
– Improvements in technology
.
64
• Closed economies with lower savings rates grow
more slowly in the short run than those with high
savings rates and tend to converge to lower per
capita GDP levels.
• Open economies experience income
convergence at higher levels.
• By impeding the inflow of foreign investment,
heavy-handed LDC governments retard growth.
65
• The problem with the arguments of the
neoclassical counterrevolution is that most
LDC economies are so different in
structure and organization from the
developed countries that the behavioural
assumptions and policy prescriptions are
often incorrect.
– Markets are hardly competitive
– The invisible hand often acts to promote the
welfare of those who are already well-off while
pushing down the vast majority.
66
Conclusions
• In an environment of widespread institutional
rigidities and severe socioeconomic inequality, both
markets and governments will typically fail.
• The linear-stages model emphasizes the crucial role
of savings and investment.
• The Lewis two-sector model emphasizes the
importance of attempting to analyze the many
linkages between the traditional sector and the
modern industry
.
67
Conclusions
• International dependence theories highlight the
role of the structure and workings of the world
economy and the impact of decisions made in
the developed world on the growth prospects for
LDCs.
• The neoclassical economic models point to the
promotion of efficient production and distribution
through a proper functioning price system and
the damaging effect of government-induced
domestic and international price distortions.
68