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Lecture 4
Economic Development Theories in Review
Harrod-Domar Model
This model, developed independently by RF Harrod and ED
Domar in the l930s, suggests savings provide the funds
which are borrowed for investment purposes.
The model suggests that the economy's rate of growth
depends on:

the level of saving: measured by the Average
Propensity to Save = APS
-APC = savings/income
example: total income $1000, and savings $200. APS
= 200/1000 = 0.2

the inverse of the productivity of capital: Measured by
the Incremental Capital Output Ratio (ICOR)
- ICOR = a required increase in capital / income
increase
For example, if $10 worth of capital equipment is
needed to produce $1 more of output, the ICOR =
10/1 = 10. The efficiency of the capital is the
inverse of 10 = 1/10.
If $5 worth of capital equipment is required to
produce one more dollar worth of output, then the
ICOR is 5/1=5. The efficiency of capital is 1/5.
Compared to the previous example, now the capital
is twice as efficient.
Mathematical-Formal Harrod-Domar Model: Calculating the
Growth Rate of GDP
The growth rate of GDP can be calculated very simply.
The ICOR is defined as the growth in the capital stock
divided by the growth in GDP. Since Investment (I) is
defined as the growth in the capital stock, the ICOR is equal
to Investment divided by the growth of GDP.
Investment will be equal to savings and Savings is equal to
the APS times GDP. If we divide both sides by the ICOR
and we divide both sides of the equation by GDP we have
the result that the growth rate of GDP will equal the
Average Propensity to Save (APS) by the Incremental
Capital -Output Ratio (ICOR).
Thus if the APS is 12% and the ICOR is 3 the growth rate of
GDP, G(Y), would be 4%.
Thus, Growth Rate = Saving Rate x Efficiency of
Capital
What is taken for granted:
The Harrod-Domar model was developed to help analyse
the business cycle. However, it was later adapted to
'explain' economic growth. It concluded that:

In general, economic growth depends on the growth of
labour L, capital K, and technology T.
Y = f (K, L; T) production function
dY = f (dK, dL; dT)
However, the Harrod Domar model has only one factor of
production, that is, capital K. Why?



As developing countries often have an abundant
supply of labour, it is a lack of physical capital that
holds back economic growth and development. In
other words, the bottleneck for the economic growth is
dK or an increase in capital.
An increase in capital comes from investment.
Investment = savings.
Implications of the model


The key to economic growth is to expand the level of
investment: capital accumulation or ‘Mobilization of
capital’ is important.
Equally important is the productivity of capital: the
lower the capital output ratio, the better.
In general, eventually, the more amount of capital,
the productivity of capital decreases:
The marginal product of capital decreases as the
amount of capital increases.
Recall: The S curve of the total output. In the
latter part of the S curve, the MP of capital is a
decreasing function of capital –“Decreasing
Marginal Returns” or “Law of Diminishing
Marginal Return”
This happens as the size of capital grows in the
natural course of economic growth.
It is a formidable task to keep the marginal
product of capital constant or even increasing.
This can be achieved by generating
technological advances or technical
innovations which enable firms to produce more
output with less capital i.e. lower ICOR
(incremental capital output ratio).
- Some countries have succeeded in mobilization
of capital, but failed in the efficient use of capital.
Eg) North Korea, East Germany
- Kozo Yamamura’s paper reports that during the
take-off stage of economic growth of Japan, the
capital output ratio fell significantly. Subsequently,
during the period of growth rates decelerating, the
capital output ratio rose steadily.

Policies are needed to encourage savings; and/or to
enhance efficiency of capital.
Problems of the model


Practically it is difficult to stimulate the level of
domestic savings particularly in the case of developing
countries where incomes are low.
One way of supplementing the low domestic savings
would be foreign savings:
However, borrowing from overseas to fill the gap
caused causes debt repayment problems later.

The law of diminishing returns would suggest that as
investment increases the productivity of the capital will
diminish and the capital to output ratio rise. Fighting
this natural law is a formidable task.
In a word, the model does not give any recipe for a
success of economic development while it explains the
surface of the given economic growth.
Lewis's Dual Sector Model of Development: The theory
of ‘trickle down’
Lewis proposed his dual sector development model in 1954.
It was based on the assumption that many LDCs had dual
economies with both a traditional agricultural sector and a
modern industrial sector.
The traditional agricultural sector was assumed to be of a
subsistence nature characterized by low productivity, low
incomes, low savings and considerable underemployment:
the marginal labor productivity is nearly zero.
The industrial sector was assumed to be technologically
advanced with high levels of investment operating in an
urban environment.
Lewis suggested that the modern industrial sector would
attract workers from the rural areas. Industrial firms,
whether private or publicly owned, could offer wages that
would guarantee a higher quality of life than remaining in
the rural areas could provide. As the level of labour
productivity was so low in traditional agricultural areas
people leaving the rural areas would have virtually no
impact on output. Indeed, the amount of food available to
the remaining villagers would increase as the same amount
of food could be shared amongst fewer people. This might
generate a surplus which could them be sold generating
income.
Those people that moved away from the villages to the
towns would earn increased incomes and this crucially
according to Lewis generates more savings.
The lack of development was due to a lack of savings and
investment. The key to development was to increase
savings and investment.
Lewis saw the existence of the modern industrial sector as
essential if this was to happen. Urban migration from the
poor rural areas to the relatively richer industrial urban
areas gave workers the opportunities to earn higher
incomes and crucially save more providing funds for
entrepreneurs to investment.
A growing industrial sector requiring labour provided the
incomes that could be spent and saved. This would in itself
generate demand and also provide funds for investment.
Income generated by the industrial sector was trickling
down throughout the economy.
Problems of the Lewis Model

Sustainable growth or steady job creation in the urban
sector is not automatic.
-The assumption of a constant demand for labour from
the industrial sector is questionable.
-Increasing technology may be labour saving, and
reducing the need for labour.
-How much can the urban sector absorb the migrants
from the rural areas?

Stability of economy might be adversely affected by
this kind of economic development. As the industry
concerned decline, the demand for labour will fall. The
industrial production may be more subject to business
cycles while there might be no business cycles in the
subsistence economy.

Will higher incomes earned in the industrial sector be
saved? If the entrepreneurs and labour spend their
newly found gains (Consumerism) rather than save it,
funds for investment and growth will not be made
available.

The rural urban migration has for many LDCs been far
larger that the industrial sector can provide jobs for.
Urban poverty has replaced rural poverty.
Rostow's Model- the Stages of Economic Development
In 1960, the American Economic Historian, WW Rostow
suggested that countries passed through five stages of
economic development.
Stage 1 Traditional Society
The economy is dominated by subsistence activity where
output is consumed by producers rather than traded. Any
trade is carried out by barter where goods are exchanged
directly for other goods. Agriculture is the most important
industry and production is labour intensive using only
limited quantities of capital. Resource allocation is
determined very much by traditional methods of production.
Stage 2 Transitional Stage (the preconditions for
takeoff)
Increased specialisation generates surpluses for trading.
There is an emergence of a transport infrastructure to
support trade. As incomes, savings and investment grow
entrepreneurs emerge. External trade also occurs
concentrating on primary products.
Stage 3 Take Off
Industrialisation increases, with workers switching from the
agricultural sector to the manufacturing sector. Growth is
concentrated in a few regions of the country and in one or
two manufacturing industries. The level of investment
reaches over 10% of GNP.
The economic transitions are accompanied by the evolution
of new political and social institutions that support the
industrialisation. The growth is self-sustaining as investment
leads to increasing incomes in turn generating more
savings to finance further investment.
Stage 4 Drive to Maturity
The economy is diversifying into new areas. Technological
innovation is providing a diverse range of investment
opportunities. The economy is producing a wide range of
goods and services and there is less reliance on imports.
Stage 5 High Mass Consumption
The economy is geared towards mass consumption. The
consumer durable industries flourish. The service sector
becomes increasingly dominant.
According to Rostow development requires substantial
investment in capital. For the economies of LDCs to grow
the right conditions for such investment would have to be
created. If aid is given or foreign direct investment occurs at
stage 3 the economy needs to have reached stage 2. If the
stage 2 has been reached then injections of investment
may lead to rapid growth.
Limitations
 Many development economists argue that Rostows's
model was developed with Western cultures in mind and
not applicable to LDCs. It addition its generalised nature
makes it somewhat limited.

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It does not set down the detailed nature of the preconditions for growth: what brings about the take-off?. In
reality policy makers are unable to clearly identify stages
as they merge together.
Rostow does predict that every economy is going
through the same stage. However, some economies are
stuck in the first stage forever while other economies
“take off”. The development pattern or growth path is not
deterministic at all. Rostow model does not tell these
differences.
Thus as a predictive model it is not very helpful. Perhaps
its main use is to highlight the need for investment. Like
many of the other models of economic developments it is
essentially a growth model and does not address the
issue of development in the wider context.
Neo-Classical Theory of Growth
Neo classical theory maintains that economic growth is
caused by:



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increase in the labour quantity (population growth)
improvements in the quality of labour through training
and education
increase in capital (through higher savings and
investment)
improvements in technology
You may recall the two building blocks for this theory from
macroeconomic theories:
(1)
In the long-run, the equilibrium national income is
determined by the long-run aggregate supply curve.
(2)
Neo-classical Production function or Long-run
Aggregate Supply curve.
Y = f(K, L : Technology) for LRAS
(3) As K, L or T rises, the LRAS curve shifts to the right
and the Yf , which shows the maximum potential level of
income, moves to the right.
Underdevelopment is seen as the result of some
bottlenecks that hinders the full utilization or accumulation
of production factors, such as K, L, or technical innovations.
For instance, first and foremost, the state intervention in
markets through regulation of prices may hinder the full
utilization of production factors. It inhibits growth because it
encourages corruption, inefficiency and offers no profit
motive for entrepreneurship.
The neo classical economists argue that for economic
growth, the bottlenecks should be removed. For instance,
government control should be removed.
They argue therefore, that very often, the root cause of
underdevelopment lies with the governments of the LDCs
themselves. Only when governments adopt polices that aim
to free up markets and improve the supply side, will the
economy grow and development occur. This results in a
shift of the long-run aggregate supply as shown in the
diagram. The potential level of output of the economy is
then higher.
Neo classical economists advocate the following strategies
should be encouraged:

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
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Competitive free markets
Privatisation of state owned industries
A move from closed (no trade) to open (trading)
economies
Opening up the domestic economy through
encouraging free trade (i.e. abolish tariffs and quotas)
and foreign direct investment.
These policies will stimulate investment, higher output and
income and hence higher savings.
Problems of the model
This model makes a number of unrealistic assumptions and
ignores a number of crucial issues


The assumption is that the creation of a free market
and a private enterprise culture is possible and
desirable.
The existence of market failure such as externalities
associated with economic growth are ignored

The problem of uneven distribution of income is
ignored.
Empirical Extension of Neoclassical Model: ‘Growth
Accounting’
This theory identifies the attribution of each factors, K, L
(=N at macro level), and T to economic growth.
The Solow model( a more sophisticated version of Neo-Classical Mo
The Solow model (for which the American economist Robert Solow was
the Nobel prize in economics in 1987) ignores the temporary ups and do
the business cycle and explains potential income (output) as it obtains in
run.
-
The main building block is the aggregate production function. While the 3
production function shows output to depend on the capital stock K and th
force or total number of workers N, the basic version of the Solow model
the labour force fixed at its normal level:
Y/N is per-person national income, or GDP/workers. This per-capita inco
better measurement of economic growth and development than just GDP
standard living depends on Y/N , not Y.
The per-capita version of the Aggregate Production Function is equal to
Y/N = F (K/N: Technology), and assume that Technology is constant.
We may then operate with the partial production function that keeps L fix
for now assume that technology is fixed as well.
Now Y/N is an increasing function of K/N for a fixed level of technology (f
The curve of per-capita Aggregate Production Function is concave. Why
The answer is that there is a diminishing marginal return to any additi
production factor while all other factors are fixed.
Y/N
Implications

The higher the K/N, the higher per capita income or output Y/N,
and thus the standard of living.

Is that the higher K/N (without the backing of a higher rate of
savings), the better? Yes, as we have seen, for one point of
time. But, not for a sustainable period of time.
Example) foreign aids of capital goods(externally increased
K/N); a one-time increase in capital(exogenously increased
K/N)
-Note that there is such a thing as “Optimal Level of Capital
Per worker or per capita, here given as K*/(N): recall the
picture is for one person, and thus K* should be read in fact as
K*/N. if actual K/N is above K*/N, there is an excessive
amount of capital(too much of investment), and if the actual
K/N of the economy is below K*/N, there is insufficient amount
of capital.
-We note that this has some elements of convergence theory:
economic growth rates would be higher when K/N is low, and
the rates will fall as K/N rises.

We can get a steady state per-capita income rising by
having a permanent and sustained shift up of
“savings curve”. The curve rises up as the domestic
savings ratio (S/Y) rises. Note that an increase in the
total amount of Savings is not sufficient, but the
savings ratio itself should rise. In other words, a larger
share of income should be saved. How does it show
on the graph?
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An easy way of increasing K/N is controlling the
population through birth control. How does it show on
the graph?
A once-and-for all increase in capital or scattered
investment does not lead to an increase in per-capita
income at all. For instance, “Great Leap Movement’
would not help bring an increase in the national
income forever. Why? How does it show on the graph?
You can add the foreign savings, through capital
inflows or foreign borrowings, to the curve. This will
lead to a higher equilibrium for the steady state
national income per person. However, this injection of
foreign investment should be continuous, not just one
shot, in order to raise the equilibrium level of percapita income. For instance, foreign aids do not help
raise the standard of living of a country permanently.
Why?
So far we have assumed that Technology is fixed.
However, you can shift up the equilibrium per-capita
income by having Technical Innovations. How does
this show in the graph?