Download U6602: Economic development for international affairs

Malgosia Madajewicz
U6602 Economic Development for International Affairs
Spring 2001
Part II: Aggregate perspectives: growth and structural change
A. Growth
1. Introduction: some empirical patterns
Country
Time period
Average annual growth rate of real per-capita income
Netherlands
1580-1820
0.2%
U.K.
1820-1890
1.2%
U.S.A.
1890-1989
2.2%
Note: at a 2% rate of growth, per-capita income doubles in 35 years

per capita GDP in OECD countries 1870-1978 increased sevenfold (on ave for all
OECD); such an increase cannot but transform societies completely

takeoff into sustained growth (W. W. Rostow) has occurred only in the last century,
and only in a handful of countries; in most developing countries, process of growth
began only post-WWII and even since then has been quite erratic

between 1960-1985 annual growth rate of real per-capita income averaged 1.9%, but
there were tremendous disparities in the growth experiences of individual nations:
-
E.Asian and S.E. Asian economies, excluding China, averaged 5.5% per year
between 1965-1990
- China averaged 8.2% between 1980-1993
- average per-capita income in Latin America fell by 11% during the 1980s
- similar declines in Africa
(show table 3.2 from Ray)

the implications of these stark differences in growth performance are tremendous, and
raise the basic question: what explains these differences?

Robert Lucas: “Rates of growth of real per-capita income are … diverse even over
sustained periods … Indian incomes will double every 50 years, Korean every 10. An
Indian will, on average, be twice as well off as his grandfather; a Korean 32 times … I
do not see how one can look at figures like these without seeing them as representing
possibilities. Is there some action a govt of India could take that would lead the Indian
economy to grow like Indonesia’s or Egypt’s? If so, what exactly? If not, what is it
about the “nature of India” that makes it so?

economic models of growth attempt to provide a framework for thinking about this
question; the models are highly aggregative (in some ways, simplistic?), reflecting the
1
methodological bias of economics towards beginning with abstract simplified models
and introducing complications as necessary
2. Review of basic concepts
a. macroeconomic accounting identities

at simplest level economic growth is the result of abstention from current
consumption. To understand this, need to understand macroeconomic balance.
(figure 3.1 from Ray as a macroeconomic balance story – inflows = outflows)

macroeconomic balance implies the following accounting identities (assuming a
closed economy and ignoring government spending):
the first equation must be true as a matter of accounting – national income is divided
between C and S
Y(t) = C(t) + S(t)
Value of produced output must match goods produced for C and I
Y(t) = C(t) + I(t)
But what is income – consumption?
S(t) = I(t)
where:
- Y(t) = total output (income) of the economy at time t
- C(t) = total consumption (expenditure on consumption goods) at time t
- S(t) = total savings at time t
- I(t) = total investment (expenditure on capital goods) at time t


this is a static equilibrium at each point in time. We’re interested in the dynamic story
– how an economy changes (grows) from period to period.
to describe the dynamic evolution of the economy, we also need to track K(t), the
capital stock of the economy at time t, which evolves according to:
K(t + 1) = (1-) K(t) + I(t)

the evolution of the economy can then be schematically represented as:
C (t )
K (t )  Y (t )  
S (t )  I (t )  K (t  1)  Y (t  1)
2

the rate of growth of aggregate output, i.e., g Y 
Y (t  1)  Y (t )
, therefore depends
Y (t )
on:
-
how the capital stock K(t) is translated into output, Y(t) (production function)
how income Y(t) is allocated between C(t) and S(t) (household or individual
utility maximization)
how S(t) is translated into I(t) (firm profit maximization)

for most purposes we will be interested in the rate of growth of per-capita output or
income, and to think about that we also need to consider the rate at which the
population is growing. Let N(t) be the size of the population in the country at time t.
N (t  1)  N (t )
Let n 
denote the population growth rate. Then, the rate of growth of
N (t )
Y (t )
per-capita output or income, i.e., y (t ) 
, will be given by:
N (t )
Y (t  1) Y (t )

N (t  1) N (t )
y
g 
 gY  n
Y (t )
N (t )
a
Note: % ( )  %a  %b for small changes.
b
b. Production functions

to capture how capital and labor are combined to produce output, we need the concept
of a production function (how much output will increase if number of spindles or of
workers goes up given amount). Production functions are mathematical relationships
characterized by the assumptions we make about what the relevant inputs are, the
degree of substitutability across inputs and returns to scale. Can be defined for given
output or at more aggregate level, firm or country. Two simple production functions
that have been widely used in the growth literature are the fixed-coefficients (also
called the Leontief) production function, and the neoclassical production function

the fixed-coefficients production function is represented in the following way:
Y  min aK , bL
where L is the amount of labor available in the economy. At the efficient amount
of K and L, Y=aK=bL, so K/L=b/a (i.e. capital labor ratio is constant), a is the
inverse of the capital-output ratio (i.e., the number of units of capital required to
make 1 unit of output), and b is the inverse of the labor-output ratio. Note that if
we assume a fixed-coefficients production function we are assuming:
- no substitutability across inputs (factors of production) – e.g. person
mowing a lawn, however is it still the appropriate representation over
the long term (e.g. size of lawn mower)?
3
-

capital-output ratio fixed
constant returns to scale
under the neoclassical production function output is given by Y  F ( K , L) , where
the function F(.) is characterized by:
-
-
diminishing marginal returns to both capital and labor, which implies, in
particular, that the capital-output ratio increases as the capital-labor ratio
increases
the possibility of factor substitution
e.g. Cobb-Douglas: Y  K  L with 0    1 and 0    1
returns to scale depend on the assumptions we make regarding  and ; for
instance:
<1
+=1
>1
decreasing returns to scale
constant returns to scale
increasing returns to scale
3. Harrod-Domar growth model


developed independently in 1940s by Roy Harrod (England) and Evsey Domar (MIT).
main assumption – output of any economic unit depends on amount of capital
invested in that unit. Essentially assumption that in a poor, labor-surplus economy,
the binding constraint is likely to be the stock of physical capital.
(growth as abstention from current consumption, figure 3.1 from Ray again as a growth
story – how growth happens, savings as leakage out of system which allows investment
and therefore growth, system in balance when S=I; ec expands when I > than needed to
replace depreciated capital, allowing next period’s cycle to recur on larger scale)
 basic equations/assumptions:
S(t) = sY(t)
I(t) = K(t + 1) – (1-)K(t) = S(t)
where s is economy-wide savings rate (total savings divided by total income), i is the
economy-wide capital-output ratio, j is the economy-wide labor-output ratio,
- we’ve assumed all three are fixed and exogenously determined
- we've assumed that the binding constraint is the stock of physical capital, i.e.
the economy has a surplus of labor

the rates of growth of aggregate output, g Y , and per-capita output, g y , can then be
determined:
4
K(t + 1) = (1-)K(t) + I(t) 
iY(t + 1) = (1-)iY(t) + sY(t) 
Y (t  1)
s
 (1   )  
Y (t )
i
s
gY   
i
s
g y    n
i

to increase growth, raise s and accumulate capital, lower i, lower n

comments/criticisms:
-
-
-
-
-
combines fundamental features underlying growth: ability to save and invest,
ability to convert capital into output, rate at which capital depreciates,
population growth
capital created by investment in plant and equipment is the main determinant of
growth and savings determine this investment
basis for Soviet planning, Indian five-year plans and other planned
industrialization strategies; estimate i, then choose g and model will tell you s
and therefore I, or choose s and model will tell you g; for whole country or by
sector, especially useful if can affect s or i
the Leontief production function assumes a fixed i, however this is likely to vary
over time and to be susceptible to policy intervention. In general, capital-output
ratio rises as ec grows, savings increase and surplus labor diminishes. However,
it also depends on efficiency with which inputs used.
assumption that s, i, and n are exogenous in the sense that there are no
endogenous feedback mechanisms from the variables being determined within
the model, i.e., K, Y, S, and I, to these "parameters"; hence, presumption that
these parameters, can be directly manipulated by governments within a
planned/command economy
think through example in which savings rate endogenous – increases and then
decreases as ec grows (and ec growth rate with it)
4. Neoclassical/Solow growth model


developed by Robert Solow and others. Endogenizes i by introducing law of
diminishing returns.
basic assumptions/equations:
Y (t )  F ( K (t ), L(t ))
S(t) = sY(t)
K  K (t  1)  (1   ) K (t )  I (t )  S (t )
L L(t  1)  L(t )

n
L
L(t )
5

assumptions about F(K, L):
-

diminishing marginal returns to each input
input substitution possible, hence capital-output ratio endogenous
constant returns to scale
constant returns to scale allows us to rescale (ratio of marginal productivities depends
only ratio of inputs, not on scale):
Y  F ( K , L)  y  f (k ) where y 
Y
K
,k 
L
L
For example:
Y  F ( K , L)  K  L1- 
Y K  L1-
K
y 
  ( )  f (k )
L
L
L

fundamental equation of the Solow model:
K (t  1)  (1   ) K (t )  sY (t ) 
1 K (t  1)
1
K (t )
Y (t )

[(1   )
s
]
L(t ) L(t  1) L(t  1)
L(t )
L(t )
L(t  1)
(
 1  1)k (t  1)  (1   )k (t )  sy (t ) 
L(t )
(1  n)k (t  1)  (1   )k (t )  sy (t )

figure below depicts the long-run equilibrium of the Solow model

the steady-state or long-run equilibrium is defined by:
k*
s
*
k (t )  k (t  1)  k  * 
n 
y
where * denotes the steady state quantity of the variable
6

comments/criticisms:
- key to difference with Harrod-Domar is diminishing marginal returns
- in the long-run, y is constant, i.e., g y  0 in the steady state, unless there is
technological progress, i.e., increases in ; in other words, technological
progress is the only source of sustained growth in y (can be put into model as
efficiency units of labor, then SS growth of per capita income at rate of tech
progress)
- but note that even in the steady state, Y continues to grow at a rate of n
k*
s
- long-run level effects: s  y SS ; n  y SS  ; * 
n 
y
-
-
-
-
-
long-run growth effects: n  g Y 
therefore in the long-run, three sources of variation in y, all of which are taken
to be exogenously determined:
 population growth rates
 savings rates
 rates of technological progress
thus if these three features are similar across economies, in the long-run we
expect to see convergence, i.e., countries that start off with lower levels of k
(and hence y) will exhibit higher growth rates in the transition to the long-run
equilibrium. This is the hypothesis of unconditional convergence. Predicts
convergence irrespective of historical starting point (i.e. two countries with
similar parameters will end up in same place regardless of where started).
hypothesis of conditional convergence admits that countries may differ in these
parameters and emphasizes instead convergence to a country-specific steady
state y
a lot of empirical research using cross-country data has been done on this;
evidence still inconclusive; some evidence for conditional convergence, i.e.
convergence to same per capita growth rate (if tech progress same across
countries), but still much more variation than in per capita income than theory
predicts (can exaggerate theoretical predictions only at cost of ascribing a
constancy of ec returns to physical capital which physical capital does not
possess, it needs labor to be productive)
also empirical research raises questions: why do saving rates and pop growth
rates remain so different across countries, if tech progress drives all growth,
what drives tech progress, diffusion etc
5. Endogenous growth models


in Solow model, growth of y cannot be sustained in the long-run because of
diminishing returns to K, except through technological progress, which is left
unmodelled (modeled in black box way)
endogenous growth models build upon Solow model by addressing these
shortcomings:
7
-
some models introduce human capital, H, as an additional form of capital that
can be deliberately accumulated and assume that F(.) displays constant returns
to scale when both factors, K, and H are included:
e.g. y  k  h1
k (t  1)  k (t )  sy (t )
h(t  1)  h(t )  qy (t )
Note: the omission of labor, L, here is intentional; what makes this model qualitatively
different from the Solow model is the fact that the production function displays constant
returns to scale in all the factors that can be deliberately accumulated; to the extent that
the labor force grows exogenously, introducing L into the production function would
make this model essentially equivalent to the Solow model.
Note: conditioning on human capital shows conditional convergence and divergence due
to human capital
-
-

other models have explicitly introduced investments in R&D that contribute to
technological progress –who chooses the level of R&D? if individual then issue
of appropriability of returns, need some degree of monopoly
still other models have focused on increasing returns to scale, externalities and
spillovers in the process of growth and capital accumulation such as those that
might arise from learning-by-doing, or from knowledge spillovers across firms,
or complementarities such as will choose to save and invest more if expect
overall ec investment to be higher in a way which affects my productivity
Comments:
-
all of these models have the implication that growth in y can be sustained in the
long-run
these models predict divergence in y across countries over time
these models have focused the policy discussion on the importance of
accumulating human capital and of increasing the knowledge base of an
economy
6. Sources of growth analysis/growth accounting




economists have attempted to determine the respective contributions of physical and
human capital and tech progress to growth
tech progress, or productivity growth, calculated as residual after all measurable
inputs accounted for
results very sensitive to procedure. Have to be very careful to properly measure
measurable inputs, since TFP is residual. E.g. WB study finding that 1/3 of growth of
rapidly growing E. and S.E. Asian economies due to TFP. Result wiped out by Alwyn
Young’s careful study (TFP growth varying from .2% in Singapore to 1.7% in S.
Korea): overest TFP growth if proxy L force with pop growth since L force
participation increased hugely, if looking for TFP in manufacturing have to account
for rural-urban migration in calculating L force, have to account for changes in K and
L, particularly changes in quality, e.g. education of L (more educated L is more L)
if don’t do exercise carefully, get distorted policy prescriptions
8
B. Structural change
1. Two-sector/dual-economy models: Lewis/Fei-Ranis



the process of economic growth typically does not affect all parts of the economy
evenly. A salient feature of the process is shift from urban to rural, agricultural to
industrial. Agriculture provides labor and food for the industrial sector. (Other links –
industry can provide inputs for agric, agric provides D for industrial output, agric
exports can earn foreign exchange for the import of inputs into industry.) How does
this interaction affect the process of growth?
Model developed by Arthur Lewis in 1954. Central feature – dual economy. Duality
may refer to traditional/modern (often equated to agric/industrial, types of techniques
of production, but perhaps most imp types of ec org family with profit distributed as
shares as opposed to capitalist based on wages), rural/urban, agric/industrial. These
often equated. The equations don’t hold up exactly but useful for organizing thoughts
(agric may rely on modern, capital-intensive techniques, informal sector in urban
areas often more usefully thought of as traditional, much of informal sector non-agric
but does not fit in with industrial classification)
Basic setup and assumptions:
-
-
-

the economy consists of 2 sectors, which may be thought of as agriculture(A)
and industry(I), traditional and modern, rural and urban, or non-capitalist and
capitalist
A-sector inhabited by peasant farmers with production function
A
is
the
stock
of
land,
which
is
QA  FA ( A, LA ) where
non-reproducible/non-accumulable. We make the following assumptions:
 diminishing marginal product of labor
 initially, L A  L so MPL A  0 , i.e. excess supply of labor
 but wA fixed at some subsistence level, w
 no investible surplus in A-sector
I-sector inhabited by capitalists/industrialists with production function
QI  FI ( K , LI ) where K is accumulable/reproducible through savings and
investment of surplus. Assume:
 diminishing marginal product of labor
 wage in I-sector, wI  MPLI
 industrialists save and invest some of their surplus, so the capital stock
grows from period to period
Static equilibrium
9

based upon the initial capital stock in the I sector, labor moves freely between
the two sectors so as to equate wages in the two sectors. (see figures below)
Dynamics
capitalists in the I-sector obtain profits which they save and invest, thereby increasing the
capital stock and hence, the marginal product of labor (at any given quantity of labor).
This in turn puts upward pressure on wages in the I-sector, inducing a flow of labor in
from the A-sector, mitigating the upward pressure on wages. This is depicted in figures
below.
- over time the I sector grows, with more and more labor shifting from A-sector to
I-sector. The growth is initially facilitated by the fact that the industrial wage is
kept low by excess supply of labor; hence industrialists benefit from growth, but
not workers. However, at some point, the excess supply of labor is used up and
then wages begin to grow as well

Critique/comments
-
-
is MPLA  0 ? Here useful to distinguish between marginal product of labor vs.
marginal product of a laborer.
As L withdrawn from agric sector there’s more income for remaining workers to
share. Why not share it and raise wage? If do then reduce agric surplus and raise
required industrial wage. Even if market surplus in response to higher prices,
second effect remains.
presumes existence of entrepreneurial/industrialist class and assumes class will
save and accumulate; but what about conspicuous consumption, capital flight?
10
-
-
ignore possible emergence of urban labor interests, unions, pushing industrial w
above the subsistence wage, and consequent behavioral responses of
industrialists in choosing more capital-intensive technologies or not investing
where does the market for industrial goods come from?
C. Aggregate measures of development
1. Gross National Product (GNP)/Gross Domestic Product (GDP)

Definitions
GNP: the sum of the value of all finished goods and services produced by individuals and
firms of an economy during a given year; equals the total income (including wages and
profits) earned by citizens of a country regardless of location/source of income, Note: in
calculating GNP we exclude intermediate goods (so as to avoid double counting); e.g. a
cattle rancher sells quarter-pound of meat to McDonalds for 50 cents, then McDonalds
sells you the burger for $1.50, GNP goes up by $1.50. Include value of domestically
consumed agricultural production, but not of “in-house” output such as child-care,
cooking, etc. Value public services at cost of provision.
- GDP: similar to GNP except it counts all income produced within the borders of
an economy by both foreigners and citizens
- Note: what does the magnitude of the difference between GNP and GDP for an
economy tell us about the economy's integration into the global economy?

GNP/GDP measures, for their drawbacks, which we go through below, offer really
the only way of aggregating across the thousands of goods and services that are
produced by an economy
a. Conceptual and practical problems

GNP/GDP measurement requires sophisticated data collection/statistical institutional
apparatus/capability, which is not always present in poorer economies; size of the
informal or underground economy in many developing economies poses a particular
problem

GNP/GDP measures based on market transactions; again, this may be a particular
problem in poorer economies because of:
-
-
prevalence of subsistence agriculture, include consumed goods produced by
households but probably large measurement error
low rates of female labor force participation
valuation of goods and services whose prices either don’t exist or may not
reflect social value, e.g. cases of monopoly, regulated prices, govt expenditures
on bureaucracy, military, space research, environmental degradation,
Note: some non-marketed expenditures are included by imputing market
expenditures; e.g. housing expenditures of homeowners are imputed by
estimating the rent a homeowner would have to pay, were he renting his home
11
-
GNP/GDP measures don't take into account the depreciation of an economy's
natural resource base
index number problems complicate cross-country and intertemporal GNP/GDP
comparisons
b. Cross-country comparisons: purchasing power parity

relative prices of traded and non-traded goods can vary substantially across countries;
also exchange rates can be distorted; this complicates cross-country comparisons

Example
Steel
Personnel
Total GNP
-
-
-
U. S.($)
Quantity
Price Value
100
200
20
2
5000 10
4
30
India(Rs.)
Quantity
Price Value
8
6000
48
30000 120
168
suppose official exchange rate (say, from the ratio of steel prices) is Rs.30/$ 1;
then India's GNP is: 168/30 = $5.6 billion  the U.S. economy is 30/5.6 = 5.35
times larger than the Indian economy
suppose instead we used U.S. (relative) prices to value Indian output (both steel
and personnel services); then India's GNP is: (200 X 8) + (5000 x 4) = $21.6
billion  the U.S. economy is 30/21.6 = 1.38 times larger
in the latter case we are, in effect, applying a purchasing power parity based
exchange rate to convert Indian output into U.S. $; a variant of this method is
being used increasingly by international organizations; it has long been used in
academic studies. Note: using Indian relative prices to value output in both
countries would have given us a slightly different answer
c. Intertemporal comparisons: index number problems

the problem of which set of prices to use to value GNP also arises in making
intertemporal comparisons. Again, the problem stems from the fact that relative
prices of different goods and services can change over time

Example
T.V. sets
Wheat
Total GNP
-
Base year(1972)
Current year(1998)
Quantity Price
Value Quantity Price Value
1
500
500
50
200
10000
150
50 7500
200
150
30000
8000
40000
what is the appropriate GNP growth index? Not 40000/8000 = 5
12
-
using base year prices:
(500  50)  (50  200)
 4.38 ; this is the Laspeyres
8000
index
-
using current year prices:
40000
 1.76 ; this is the Paasche
(200  1)  (150  150)
index
either one is a more correct index of GNP growth than the ratio of GNP in the
two years with GNP in each year being valued at that year's prices
since in most countries industrial sector grows faster than agric sector, prices
which give industrial sector larger weight in national product will result in
higher growth rate
2. Human Development Index
a. Definition

the Human Development Index (HDI) is constructed by taking the simple average of
indices of life expectancy, educational attainment and adjusted (PPP) real GDP per
capita for an economy
b. Conceptual issues

which measures of economy - wide development should be included? why focus on
only these three?
 how should indices of achievement along each of these dimensions be constructed?
how should achievements along these different dimensions be weighed? what are the
weights implicit in taking a simple average of the three indices of achievement?
D. History, expectations, coordination failures and linkages

History and expectations interact and work through two main channels:
complementarities and increasing returns
1. Complementarities, coordination failures and linkages
an economic activity is said to involve an externality when the fact that an economic
agent is undertaking that activity has an effect (positive or negative) on other economic
agents that is not mediated (internalized) through a market mechanism; divergence
between individual cost and social gain; can think of this in terms of missing market

cab-fares in Atlanta went up during the 1996 Olympics – does that mean that the
visitors to the Olympics imposed a negative externality on local residents?
the increased levels of traffic during the Olympics resulted in higher levels of
noise and air pollution – is that an example of a negative externality?
an economic activity is said to involve positive complementarities – which are a
special case of positive externalities – when the fact that an agent is undertaking that
activity, not only has a positive effect on other agents, but also increases their
13
incentives to engage in that activity; one individual’s action affects others’ relative
preferences for choosing similar actions; e.g. cost of adopting a system depends on
how many other people have adopted it
-
-

safe driving is an example of an activity that provides a positive externality but
does not involve complementarities - the fact that you are driving safely need
not induce others to drive safely
investment (and capital accumulation) can sometimes be an example of an
activity characterized by complementarities; a firm's decision to invest can
sometimes raise the rate of return on the capital stock of other firms - a positive
externality - but in doing so, also raises the other firms' incentives to invest
themselves, which is an instance of complementarities at work
the figure below provides an example of complementarities, illustrating the
economics of QWERTY

historical lock-in or Pareto-comparable multiple equilibria can occur only when the
externality is positive; figure below provides an example of anti-complementarities,
for example due to congestion effects; clearly in this case history can have no effect,
both roads will be used regardless of which was put in first

insights:
-
the presence of complementarities raises the possibility of multiple equilibria to
which an economy might converge
both the history (of past actions and choices) - this is what is meant by path
dependence or historical lock-in - as well as expectations/beliefs (about future
choices) determine which particular equilibrium an economy actually converges
to
14
-
the possibility of multiple equilibria and historical lock-in arises only when
externalities take the form of complementarities

basic idea: in the presence of complementarities, history (past patterns of activity) as
well as expectations/beliefs (about others' future actions) become very important in
determining aggregate outcomes

pervasive complementarities, by raising the possibility of multiple equilibria, suggest
the possibility that economies might get trapped in a "low-level" equilibrium or
vicious cycle of poverty; the phenomenon of poverty and underdevelopment may
therefore be the outcome of a massive coordination failure

Example: Rosenstein-Rodan's parable of the shoe factory
-
shoe factory that produces $1,000,000 worth of shoes (and hence $1,000,000
worth of wages, profits and rent) cannot by itself survive if all the shoes have to
be sold locally simply because people will want to buy things other than shoes.
Suppose the local population would like to spend 50% of their income on food,
30% on clothing, and 20% on shoes, and imagine that three factories were set
up: a food factory to produce $500,000 worth of food, a clothing factory to
produce $300,000 worth of clothing, and a shoe factory to produce $200,000
worth of shoes. All three would be jointly viable, whereas each individually
would not. But suppose no single entrepreneur is large enough to set up all
three. There are then two possible equilibria:
a "good!' equilibrium where each of three entrepreneurs invests because she believes the
other two will invest
 a "bad!' equilibrium where none invest because each believes the
others will not; this latter equilibrium is characterized by a
coordination failure


big-push/balanced growth: Rosenstein-Rodan argued that to overcome such
coordination failures, which can arise both because of lack of demand, as in the above
example, as well as supply bottlenecks, governments needed to coordinate a "big
push" industrialization effort along a broad front (i.e., multiple sectors); this is also
often referred to in terms of the need to pursue a balanced growth path. Requires
massive gov’t investment in many sectors at once and quantitative allocation of I
across sectors – how know the right allocation? Also, this does not exploit fact that
desirable outcome is also an equilibrium (as the following does).
linkages: Hirschman's response was that backward and forward linkages also play a
role; basic idea is that the development of one sector (perhaps with government
support) will stimulate/induce investment in those sectors, because it creates supply
for downstream sectors and demand for upstream sectors, without the need for active
government intervention
-
an industry A is said to have a forward linkage to another industry B when
expansion of A increases the availability of some input needed by B, thereby
easing the supply of good/service produced by industry B
15
-
-
-
-
-
an industry B is said to have a backward linkage to another industry A if
expansion of the former raises the demand for the good/service produced by the
latter
the following figure provides illustrative examples of backward and forward
linkages
focus on linkages suggests an alternative policy of unbalanced growth where
key or leading sectors, i.e., those with strong linkages (especially backward
linkages) to other sectors, are identified and selectively promoted, in the hope
that the market pressures created by these linkages will then automatically foster
the growth of other sectors
how identify which sectors to develop? (a) number of linkages, (b) strength of
linkages (forward vs backward), (c) “intrinsic profitability” of each sector – govt
would do best to invest in least profitable one. Possible examples of leading
sectors: heavy industry, exports, tourism, transportation, agriculture
the magnitude of linkages can be estimated by analyzing input-output matrices;
input - output matrices implicitly assume a fixed coefficients technology and
can be constructed at as disaggregated a level as data permit; for instance an
input-output matrix for an economy with four goods might look like:
units
needed of

Good 1
Good 2
Good 3
Good 4
Good 1
a11
a21
a31
a41
To produce 1 unit of
Good 2 Good 3 Good 4
a12
a13
a14
a22
a23
a24
a32
a33
a34
a42
a43
a44
issues to keep in mind:
-
role of credit market imperfections
role of domestic market size, possibility of trade
coordination problem may require one, short-term intervention, unlike
externalities which require sustained regulation
role of beliefs and expectations
2. History vs. expectations

analysis so far suggests that while history can lead an economy to a bad equilibrium,
self-fulfilling expectations can lead an economy to a better equilibrium; so what is the
relative role of history and expectations?
16


In econ expectations may not play as strong a role as in fashion. Historical lock-in
effects can be hard to overcome because structural changes take time and occur
gradually; even if I believe that everyone will eventually be using a new operating
system, I have an incentive to delay switching to the new system till the early users
have identified the bugs and they've been fixed, until new software is made available
for use on that system, etc.; what matters therefore is whether the first movers (early
adopters, innovators) gain some advantage from moving first; only in those instances
will coordination failures not arise or can be overcome without external intervention
Expectations can play a very strong role when some advantage in being an early
mover, e.g. maybe get better jobs if get there first or don’t face costs of congestion
(e.g. initially cheap housing if new tech allows move out of city)
3. Increasing returns






a production activity is said to display increasing returns to scale if an expansion of
output (scale) lowers the unit costs of production
the presence of IRS can have very similar effects as complementarities, in fact
complementarities can be seen as sort of IRS at a more aggregate, social level
ability to realize gains from production depends on size of available market, at the
same time size of market may depend on ability to exploit increasing returns, expand
production and pay out income.
New tech may not be developed if perceived that will not be able to invade mkt. May
not develop more appropriate techs than ones which currently command mkt (e.g.
imported from developed countries)
Again mult equil possible – (1) small mkt, little D for final good, intermediate input
industries can’t operate at viable level, input prices high, employ mostly L, low
productivity, low wages, stay poor, (2) large D, allows IRS to be exploited in
intermediate goods, prices of inputs go down, substitute away from L, increase
productivity, higher wages, more D
Imp to remember that small mkt argument relies on assumption of little trade
4. Other roles for history: social norms, persistence of status quo (because of
problems with identifying and/or compensating gainers and losers)
E. Inequality, growth and development
1. Inequality and growth: interrelationships

Inequality of what? Current income, wealth, lifetime income. Mostly only data on the
first. Latter two perhaps more important. Big problem with current income, point of
time at which measure it.
a. Inequality and savings

one link between inequality and growth comes from the relationship between the level
of income inequality in an economy and the economy's aggregate savings rate. The
direction of the link depends on whether marginal savings rates are increasing or
17
decreasing with income. How does this work? Compare two different settings. In one,
construction worker making $5,000 a year and investment banker making $55,000 a
year. In another, two professors making $30,000 a year each. In which case are
savings higher?

Factors that might lead to differential savings rates at different levels of income:
-


subsistence needs
aspirations for upward mobility
conspicuous consumption
in very poor countries redistributive policies may limit growth – but how do we feel
about recommending inegalitarian policies
savings behavior can also affect evolution of inequality – through evolution of
standards which people aspire to if the rich set the standard for everybody else. If
egalitarian to begin with, stay that way. If big differences, middle class may catch up
to the rich by saving a lot, while poor may not be able to save enough to do any
catching up. Another example of history mattering.
b. Inequality and redistributive politics

inequality may retard economic growth by increasing political pressures for
redistributive policies. However, it is important to distinguish between:
-

redistribution of assets, i.e., taxes on the stock of wealth; redistribution of wealth
can have positive growth effects if it facilitates human capital investment, or
eases the effects of capital market imperfections (example of East Asian tigers)
redistribution through taxes on increments to wealth, i.e., capital income,
reduces incentives to invest and thus can be a hurdle to growth.
inequality can lead to political instability and conflict that creates an environment of
uncertainty, which discourages investment. When is growing inequality likely to lead
to political unrest? Hirschman talks about the tunnel effect which nicely captures the
dynamics of political tolerance for inequality
c. Inequality, market size and demand composition
18


inequality, by determining the composition of aggregate demand, can affect the
market size for certain products; if production involves learning-by-doing or
significant fixed costs, small size of market may retard development of these sectors,
potentially slowing the process of industrialization. But keep in mind that the
limitations of domestic market size can, in principle, be overcome by targeting export
markets.
Income determines not only level of consumption but also its composition, e.g. falling
share of food items as incomes rise. D composition can also affect distribution of
incomes. If high D for luxury goods in highly unequal environment, and if luxury
goods capital-intensive, perpetuate inequality, if L intensive may reduce it.
d. Inequality, capital market imperfections, investment and human capital
development


capital markets are imperfect in the sense that an individual's capacity to borrow is
usually linked to their ability to provide collateral. Thus, to the extent that credit is
necessary to start a small business, pay for education, buy yield-enhancing inputs, or
any form of productivity - enhancing investment, the poor, who cannot provide the
necessary collateral to obtain credit, will be unable to make such investments. Other
than the obvious human cost that this implies, inequality can reduce the overall level
of investment and lead to a mismatch of funds and investment ideas/opportunities.
in the presence of capital market imperfections, there is a tendency for inequality to be
perpetuated (in some cases, exacerbated) from generation to generation. Again history
matters.
2. Measuring inequality
a. Conceptual issues




should we care about inequality in current income, wealth, or lifetime income?
Moving from short-term to long-term considerations. Concern about short-term
inequality should depend on what we know about mobility. In other words, what
should we use to measure the welfare of individuals and households?
should we care about inequality across households, or inequality across individuals; in
the latter case we also have to worry about intrahousehold inequality
should we care only about inequality in outcomes (vertical inequality), or do we also
care about inequality in treatment (horizontal inequality) regardless of outcomes?
Also functional or personal income distribution? Former concerns how people earn
what they do, i.e. ownership structure (why would functional matter – (1) where
income comes from may influence welfare (e.g. charity vs earnings), (2) functional
distribution affects rel between inequality and growth)
should we care about inequality at all, i.e, should our focus instead be on poverty?
b. Lorenz curves

in practice, usually focus on measures of vertical inequality (i.e., inequality in
outcomes),
and
the
outcome
measure
is
usually
income/consumption/wealth/landholding
19

household-survey data and/or Census data can be used to plot the distribution of
income (or whatever the outcome measure is that we choose) in a country

several ways of depicting the distribution of income:
-
histograms (i.e., for each income level (or range) plot the fraction of individuals
with income lying in that range)
cumulative distribution function (i.e., for each income level, plot the fraction of
individuals with incomes below that level)
for discussions of inequality the preferred way is often the Lorenz curve. To
generate a Lorenz curve:
 order the households by income, from poorest to richest
 for each percentile of the population, starting from the poorest, plot the
cumulative proportion of the population against the cumulative
proportion of overall income earned by households
Example: Following figure depicts the Lorenz curve for the following economy with four
individuals
Individual
Cumulative proportion
Income
of population
1
20
25%
2
30
50%
3
50
75%
4
100
100%
Cumulative proportion
of income
20
10% =
200
20  30
25% =
200
20  30  50
50% =
200
20  30  50  100
100% =
200
c. Cross-country and intertemporal comparisons

Lorenz curves offer a convenient way of summarizing the distribution of income, and
the extent of inequality and facilitates cross-country and intertemporal comparisons of
inequality
20

if the Lorenz curve for country/time period 1 lies everywhere outside the Lorenz
curve for country/time period 2, as in the figure below, then country/time period 1 has
a more unequal distribution

however, if the Lorenz curves cross, comparisons become harder to make at an
aggregate level
d. Gini coefficient/Gini concentration ratio

a common way of summarizing the information captured in a Lorenz curve that
avoids the problem described above is to compute the corresponding Gini coefficient
(Gini concentration ratio), which is defined as the ratio of the area between the
Lorenz curve and the 45-degree line, and the area of the triangle below the 45-degree
line. Thus a Gini coefficient of 0 (coincides with 45-degree line) implies perfect
equality while a Gini of 1 implies perfect inequality.

here are the Gini coefficients for several countries during the 1980s:
Bangladesh
Brazil
Hong Kong
Japan
United States
.280
.610
.400
.282
.369
e. Coefficient of variation

a particularly simple way of measuring inequality is to compute the coefficient of
variation of income (or whatever the relevant variable is) within a country. From
household survey data or the Census it is usually possible to estimate the standard
deviation and mean of income for a population. The coefficient of variation is then
simply the ratio of the two, i.e., a measure of the variation in income relative to the
mean income.

When Lorenz curves can be compared Gini coefficient and coefficient of variation
give the same ranking, consistent with Lorenz curves. However, when Lorenz curves
cross these may give contradictory rankings, flagging crossed Lorenz curves and
telling us that comparison is not clear-cut.
3. Empirical patterns and evidence
21

inverted-U hypothesis/Kuznets curve: observation that for a limited cross-section of
countries, the level of inequality tends to initially rise with increasing per-capita
income, and then subsequently decline:
Per-capita income(1965 U.S.$)
Less than 100
101 to 200
201 to 300
301 to 500
501 to 1000
1001 to 2000
2001 and higher


have to be careful in interpreting such data, e.g. is it just a Latin America effect (most
middle income countries are latin american and high inequality for whatever reason in
latin america). Also problem with gini in that crossing Lorenz curves while gini may
be increasing and decreasing. In fact inverted U goes away when control for parallel
shifts (fixed effects for countries)
cross-country evidence on initial inequality and subsequent growth (Alesina and
Rodrik):
Dependent variable: per-capita growth, 1960-85
Variable
1960 per-capita income
1960 primary enrollment rate
1960 income Gini coefficient
1960 land Gini coefficient
Democracy x land Gini

Average Gini Range of Gini
0.419
0.33-0.51
0,468
0.26-0.50
0,499
0.36-0.62
0.494
0.30-0.64
0.438
0.38-0.58
0.401
0.30-0.50
0.365
0.34-0.39
Coefficient (t-statistic)
-0.39(4.63)
2.62(2.53)
-3.45(l.79)
-5.24(4.32)
0.12(0.12)
what drives this? Lower inequality encouraging S and I or political redistribution?
Not known.
F. Poverty
1. Measuring poverty
a. Conceptual issues

conceptual issues that one faces in measuring poverty include:
-
-
in terms of which variable should poverty be defined? Common choices include
caloric intake, broader measures of consumption, income, landholding, etc.
Usually only have data on income
household or individual? Usually only have data on households. This neglects
issues of intra-household distribution. Also larger households often have more
children who consume less – need adult equivalence scales. Also, fixed costs in
setting up household, which larger households can be spread over larger # of
members.
22
-
-
-
how should a poverty line be chosen ? Keep in mind that any choice is
ultimately somewhat arbitrary. Fuzzy pointers to a deeper, less quantifiable
concept.
are notions of relative poverty as opposed to absolute poverty meaningful (or is
the former simply inequality in another guise)? Minimum necessary to function
in a society is likely to differ across societies, e.g. need for clothes, types of
clothes, transportation, housing. Need to be evaluated relative to prevailing
socioec standard, can’t be given absolute meaning. While poverty lines may
have to vary across countries for these reasons, this can be taken too far.
should the focus of policy be on transient or chronic poverty?
in estimating the poverty status of a household, how should access to public
goods, non-marketed items, subsidized health care, etc. be treated?
b. Head-count ratio

Definition: HCR = fraction of the population that is poor, i.e, have incomes less than
z, the poverty line

the main advantages of the HCR as the measure of poverty in an economy are that it's
intuitive, easily explained, and easily calculated; the primary drawback is that it's
insensitive to the distribution of income among the poor. For instance, a government
policy that results in a transfer of income from the poorest of the poor to the least poor
of the poor might lower the HCR, but would seem objectionable from an ethical
perspective. Also, policy based on HCR, e.g. minimize HCR, would lead to transfers
to the wealthiest of the poor since its easiest to move them above the line. Another
drawback is that it gives no indication of how poor the poor are.
c. Poverty gap/Income gap ratio
• the poverty gap in an economy is defined as:
z  yp
where y p is the mean income of those below the poverty line

the income gap ratio (IGR) expresses the poverty gap as fraction of the poverty line,
i.e.:

the IGR provides a measure of the depth of poverty and hence of the resources
required to eliminate poverty; because it does not focus on the numbers of people
classified as poor, it is in some ways less manipulable by policy makers. But it goes
too far in ignoring the actual numbers of people who are poor.
Both HCR and IGR ignore relative deprivation, or inequality, among the poor. E.g.
price of rice increased in Java, Indonesia in 1981. Poor who are rice farmers helped by
this. However, poorest are landless laborers or marginal farmers who are net
consumers of rice and therefore hurt by this. But HCR and IGR went down. (need
transfer-sensitive measures which would go up as a result)

d. Foster-Greer-Thorbecke class of measures/Sen's index
23

Amartya Sen proposed an axiomatic approach to defining a poverty measure; he
suggested that a poverty measure should have the following desirable properties:
-

if the number of the poor increases, the measure should go up
if the poor get poorer, the measure should go up
if the distribution of income among the poor becomes more unequal, the
measure should go up
the HCR satisfies the first but not the latter two conditions; the IGR satisfies the
second, but need not satisfy the other two; Sen proposed an index of poverty which
satisfied all three conditions

Foster, Greer, and Thorbecke, building upon Sen's work proposed a specific
functional form for poverty measures, which depending on the choice of a key
parameter, , reduces to one of the other poverty measures. The general formula is:
z  yi 
1
P   (
)
N yi  z z
where N is the total number of individuals in the economy, and yi is the income of
individual i. Note that each choice of  yields a different poverty measure. For instance:
P0  HCR
P1  IGR
P2  HCR[ IGR 2  (1  IGR) 2 C p2 ]
where Cp is the coefficient of variation of income among the poor.
 As  increases above 1, FGT index puts greater weight on larger poverty gaps making
measure more sensitive to these gaps and therefore to issues of distribution.
 Case of  = 2 esp interesting. With no inequality poverty can be captured through
some combination of HCR and IGR. However, inequality increases poverty and its
effect captured by coefficient of variation. This case also makes boundary above
which index acquires transfer sensitivity (regressive transfer between two people
should matter more if starting incomes of both people reduced equally)
2. Empirical patterns of poverty




Inequality often implies poverty but no necessary relationship between the two.
World Bank has experimented with two universal poverty lines, $275 and $370 per
person in 1985 PPP prices (poverty lines of some of the poorest countries fall between
these, lower figure coincides with poverty line for India). According to the latter, in
1990 over 1 billion individuals below poverty line (600 million according to lower
line). Percentage of people in poverty, approximately 30% of total population in
developing countries constant over this period, but absolute numbers rising
significantly.
Poverty associated with large households – this may not hold up once control for
adult-equivalence, fixed costs. Causality not clear.
Poverty associated with rural areas, lack of assets (e.g. landlesness)
24


Poverty associated with malnutrition, although interestingly, no direct relationship
between increases in income and nutrition (caloric intake increases but often
substitute towards less nutritious foods)
Poverty associated with females – related to functional effects of poverty; poorest
households may need to concentrate available nutrition on breadwinners (relationship
much more complicated than this)
25