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Theories of Economic Development
What is Economic Development?
Economic Development occurs with the reduction and elimination of
poverty, inequality and unemployment within a growing economy.
Gini coefficient This is a statistical measure of income distribution. A
Gini coefficient of 0 means perfect equality.
Human Development Index (HDI) Measures a country's average
achievements in three basic dimensions of human development: life
expectancy, educational attainment and adjusted real income (PPP$ per
person).
What do theories and models try to do?
Economic development theories and models seek to explain and predict
how:
- Economies develop (or not) over time
- Barriers to growth can be identified and overcome
- Government can induce (start), sustain and accelerate growth with
appropriate development polices
Theories are generalizations. While Less Developed Countries (LDCs)
share similarities, every country’s unique economic, social, cultural,
and historical experience means the implications of a given theory vary
widely from country to country.
There is no one agreed “model of development”. Each theory gives an
insight into one or two dimensions of the complex process of
development. For example, the Rostow model helps us to think about
the stages of development LDCs might take, while the Harrod-Domar
model explains the importance of adequate savings in that process.
Economic Development Concepts:
Absolute advantage Occurs when a country or region can create
more of a product with the same factor inputs.
Comparative advantage The basis of standard free trade theory.
First introduced by David Ricardo in 1817. Ricardo predicts all
countries gain if they specialize and trade the goods in which they have
a comparative advantage. Comparative advantage exists when a
country has a margin of superiority in the production of a good or
service i.e. where the opportunity cost of production is lower. This is
true even if one of the trading nations is more productive in all traded
goods (has an absolute advantage) compared to the other country.
The Rostow Linear Stages Model
This is a linear theory of development. It argues that to achieve
?modernity? all countries pass through the same stages of development
Economies can be divided into primary, secondary, and tertiary sectors.
The history of developed countries suggests a common pattern of
structural change:
The Harrod-Domar Savings Model
The Harrod-Domar
model developed in the l930s suggests that a population’s savings
provide the funds, which are borrowed for investment purposes. Higher
rates of savings can be transferred into higher rates of investment to
generate self-sustaining economic growth.
The Lewis Dual Sector Model
The Lewis model is structural
change model that explains how labor transfers in a dual economy. For
Lewis growth of the industrial sector drives economic growth.
Balanced Growth Theory
Balanced growth (or the big push)
theory argues that as a large number of industries develop
simultaneously, each generates a market for one another.
Unbalanced Growth Theory
Unbalanced growth theorists
argue that sufficient resources cannot be mobilized by government to
promote widespread, coordinated investments in all industries.
Therefore, government planning or market intervention is required in a
few strategic industries. Those with the greatest number of backward
and forward links to other industries are prioritized.
Major Economic Development Models
Rostow
This is a linear theory of development. Economies can be divided into
primary secondary and tertiary sectors. The history of developed
countries suggests a common pattern of structural change:
Stage 1 - Traditional Society:
Characterized by subsistence economic activity i.e. output is consumed
by producers rather than traded, but is consumed by those who
produce it; trade by barter where goods are exchanged they are
'swapped'; Agriculture is the most important industry and production
is labor intensive, using only limited quantities of capital.
Stage 2 - Transitional Stage:
The precondition for takeoff. Surpluses for trading emerge supported
by an emerging transport infrastructure. Savings and investment grow.
Entrepreneurs emerge.
Stage 3 - Take Off:
Industrialization increases, with workers switching form the land to
manufacturing. Growth is concentrated in a few regions of the country
and in one or two industries. New political and social institutions evolve
to support industrialization.
Stage 4 - Drive to “Maturity”
Growth is now diverse supported by technological innovation.
Stage 5 - High Mass Consumption
Implications of Rostow's model
Development requires substantial investment in capital equipment; to
foster growth in developing nations the right conditions for such
investment would have to be created i.e. the economy needs to have
reached stage 2.
For Rostow:
o Savings and capital formation (accumulation) are central to the
process of growth hence development.
o The key to development is to mobilize savings to generate the
investment to set in motion self generating economic growth.
o Development can stall at stage 3 for lack of savings – 15-20% of GDP
required. If the domestic Savings rate is 5%, then international aid/loan
must total 10-15% in order to plug the ‘savings gap’. Resultant
investment means a move to stage 4 Drive to Maturity and selfgenerating economic growth
Limitations of Rostow's Model
Rostow's model is limited. The determinants of a country's stage of
economic development are usually seen in broader terms i.e. dependent
on:
o the quality and quantity of resources
o a country's technologies
o a countries institutional structures e.g. law of contract
Rostow explains the development experience of Western countries, well.
However, Rostow does not explain the experience of countries with
different cultures and traditions e.g. Sub Sahara countries which have
experienced little economic development.
Introduction to the Harrod-Domar model
The Harrod-Domar model developed in the l930s suggests savings
provide the funds, which are borrowed for investment purposes.
The economy's rate of growth depends on:
- the level of saving and the savings ratio
- the productivity of investment i.e. economy's capital-output ratio
For example, if £8 worth of capital equipment produces each £1 of
annual output, a capital-output ratio of 8 to 1 exists. A 3 to 1 ratio
indicates that only £3 of capital is required to produce each £1 of output
annually.
Further Analysis
The Harrod-Domar model developed in the 1930’s to analyze business
cycles. it was later adapted to ‘explain’ economic growth.
- Economic growth depends on the amount of labor and capital i.e. ?NY
= f(K,L)
- Developing countries have an abundant supply of labor. So it is a lack
of physical capital that holds back economic growth hence economic
development.
- More physical capital generates economic growth. (use Production
Possibility Boundaries to illustrate)
- Net investment (i.e. investment over and above that needed to replace
worn out capital (deprecation) leads to more producer goods (capital
appreciation) which generates higher output and income. Higher
income allows higher levels of saving
Implications of the Harrod Domar Model
Economic growth requires policies that encourage saving and/or
generate technological advances, which lower capital-output ratio.
Criticisms of the model
Domar on Domar: My purpose was to comment on business cycles, not
to derive "an empirically meaningful rate of growth."
- It is difficult to stimulate the desired level of domestic savings
- Meeting a savings gap by borrowing form overseas causes debt
repayment problems later.
- Diminishing marginal returns to capital equipment exist so each
successive unit of investment is less productive and the capital to output
ratio rises.
- The amount of investment is just one factor affecting development e.g.
supply side approach (free up markets); human resource development
(education and training)
- Economic growth is a necessary but not sufficient condition for
development
- Sector structure of the economy important (i.e. agriculture v industry
v services)
Lewis Model - An Overview
The Lewis model is structural change model that explains how labor
transfers in a dual economy. For Lewis growth of the industrial sector
drives economic growth. The Lewis Model argues economic growth
requires structural change in the economy whereby surplus labor in
traditional agricultural sector with low or zero marginal product,
migrate to the modern industrial sector where high rising marginal
product.
Transferring surplus labor from rural to urban areas has no effect on
agricultural productivity as MP of rural workers = 0.
Firm’s profits are reinvested. Growth means jobs for surplus rural
labor. Additional workers in urban areas increase output hence
incomes and profits. Extra incomes increase demand for domestic
products while increased profits fund increased investment. Hence
rural urban migration offers self-generating growth.
The ability of the modern sector to absorb surplus works depends on
the speed of investment and accumulation of capital. Where firms invest
in new labor saving capital equipment, surplus workers are not taken
on by the formal sector. Recently arrived rural migrants join the
informal economy and live in shantytowns
Given urban growth drives economic growth it can lead to the neglect
of agriculture by government
Neglect of Agriculture – yet most people live in rural areas where
incomes are relatively low
Increased profits may be invested in labor saving capital rather than
taking on newly arrived workers
For many LDC's, rural urban migration levels have been far greater
than the formal industrial sector’s ability to provide jobs. Urban
poverty has replaced rural poverty.
Dependency theory - An Overview
Dependency refers to over reliance on another nation. Dependency
theory uses political and economic theory to explain how the process of
international trade and domestic development makes some LDC's ever
more economically dependent on developed countries ("DC's").
Dependency theory refers to relationships and links between developed
and developing economies and regions.
Dependency theory sees underdevelopment as the result of unequal
power relationships between rich developed capitalist countries and
poor developing ones.
Powerful developed countries dominate dependent powerless LDC's via
the capitalist system. In the Dependency model under development is
externally induced (i.e. DC not LDC’s fault) system. Growth can only
be achieved in a closed economy and pursue self-reliance through
planning.
Dominant DC's have such a technological and industrial advantage that
they can ensure the ‘rules of the game’ (as set out by World Bank and
IMF) works in their own self-interest.
This partly explains the hostility shown towards the WTO in Seattle in
1999.
In this model under development is externally induced (i.e. DC not
LDC’s fault) and only a break up of the world capitalist system and a
redistribution of assets (e.g. elimination of world debt) will ‘free’ LDC's
Balanced Growth Theory
Balanced growth involves the simultaneous expansion of a large
number of industries in all sectors and regions of the economy.
Balanced growth (or the big push) theory argues that as a large number
of industries develop simultaneously, each generates a market for one
another.
If a large number of different manufacturing industries are created
simultaneously then markets are created for additional output. For
example, firms producing final goods can find domestic industries that
can supply them with their inputs. The benefits of growth are spread
over all sectors and, ideally, regions.
Balanced growth theory is an extension of Say’s Law the demand for
one product is generated by the production of others
It is argued that free markets are unable to deliver balanced growth
because entrepreneurs:
- Do not expect a market for additional output – why risk resources
when sales are uncertain?
- Require skilled workers but are not willing to hire and train unskilled
staff who may then leave to work for rival firms – employers cannot
‘internalize their positive externalities
- Do not anticipate the positive externalities generated by the
investment of other firms engaged in expansion
- Are unable to raise finance for projects
If government can co-ordinate simultaneous investment in many
industries one firm provides a market for another. This requires state
planning and intervention to:
- Train labor
- Plan and organize the large-scale investment program.
- Mobilize the necessary finance
- Nationalize strategic industries and undertake infrastructure
investments e.g. build roads
- Protect infant industries through tariff (tax on imports) and quota
(limit on quantity of imports) policies
The strategy of balanced growth is beyond the resources of most poor
countries; Balanced growth within a closed economy rather than
specialization and trade contradicts comparative advantage
Government planning results in government failure i.e. government
intervention in the market fails to bring about an efficient allocation of
resources e.g. planning process creates a bureaucracy.
LDC development policies focusing on import substitution, agricultural
self-sufficiency and state control of production yield poor growth.
Unbalanced Growth Theory
Unbalanced growth theorists argue that sufficient resources cannot be
mobilized by government to promote widespread, coordinated
investments in all industries.
They share analysis with balanced growth theorists that free markets,
alone, cannot generate development but differ in that government
planning or market intervention is required just in strategic industries.
Those with the greatest number of backward and forward links are
prioritized.
A country lacks resources to finance balanced growth. Resources are
therefore concentrated on strategic industries with:
- Significant forward linkages i.e. firms creating essential inputs for
other key firms in the economy
- Significant backward linkages i.e. key firms buy industrial inputs
from a large number of domestic firms
- Import substitution. Developing domestic industries replaces imports
and so improves the balance of payments.
Government identifies strategically important areas with significant
backward and forward linkages to
- Nationalize (planned economy) or
- Subsidies (market economy).
E.g. State owned development banks finance priority investment
projects chosen for their contribution to growth and development goals.