Copyright © 2009 Pearson Addison-Wesley. All rights reserved. Chapter 3 Classic Theories of Economic Growth and Development

Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 3-2 Class Theories of Economic Development – Four Approaches Structural change model – Linear stages of growth – Saving-investment – Rural-urban migration Neocolonial dependence theory – Dependence: Center vs. Periphery – False Paradigm Neoclassical theory – Market friendly approach – Dualistic approach – Public choice approach

Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 3-3 Rostow’s Linear-Stages Model 1.Traditional society 2.Pre-condition to take-off 3.Take-off 4.Drive to maturity 5. Age of high mass consumption

Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 3-4 Rostow’s Linear-Stages Model 1.Traditional society: slow economic and population growth 2.Pre-condition to take-off: development of institutions, organizations, and infrastructure 3.Take-off: large investment in selected industry (10 to 15% of GDP)

Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 3-5 Rostow’s Linear-Stages Model 4.Drive to maturity: sustained growth of the industry and economy 5.Age of high mass consumption: production of consumer goods and services to serve an affluent society

Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 3-6 Rostow’s Linear-Stages Model t1t1 t2t2 Take-off Time GDP Growth Pre Take-off Post Take-off Economic Growth

Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 3-7 Harrod-Domar Growth Model S = sY S=Saving; Y=Real GDP; s=Saving Ratio I = ΔK I=Investment; ΔK=Capital Accumulation S = I Saving-Investment identity Define the Marginal Capital-Output Ratio as k = ΔK/ΔY Write ΔK = kΔY or I = kΔY From S = I, write sY = kΔY or ΔY/Y = s/k

Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 3-8 Harrod-Domar Growth Model The source of growth is saving and investment in production of goods and services. Accordingly, s = national saving ratio; k = marginal capital-output ratio If s=6% and k=3, then GDP growth rate=2%. Given k=3, to raise growth rate to 4%, we need to increase the saving ratio from 6% to 12% with 6% of foreign saving GDP growth rate = s/k

Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 3-9 Criticism of Investment Models Many LDCs have not been able to take-off or achieve maturity despite massive foreign investment Many nations have neglected the development of institutions, organizations, and infrastructure required for industrialization

Copyright © 2009 Pearson Addison-Wesley. All rights reserved The Lewis Development Model Rural agricultural sector – Low or even zero Marginal Product of Labor so that labor is a redundant factor and wage rate is at the subsistence level Urban industrial sector – Rising demand for unskilled labor to be trained for industrial growth results in greater employment and more profits and higher wages Rural-Urban migration – To find jobs and earn higher wages

Copyright © 2009 Pearson Addison-Wesley. All rights reserved Demand for Labor Employment Wage WRWR WUWU SRSR D U1 D U2 E1E1 E2E2 Wage Profit R: Rural U: Urban W: Wage E: Employment D: Labor DemandS: Labor Supply Investment in urban areas increases the demand and employment for rural labor.

Copyright © 2009 Pearson Addison-Wesley. All rights reserved Criticisms of Lewis Model Industrial technology is generally capital intensive/labor-saving. Hence, the demand for unskilled rural labor would not increase employment Industrialization must be supported by agricultural development to supply an ever-increasing supply of food items and raw materials

Copyright © 2009 Pearson Addison-Wesley. All rights reserved Demand for Labor Employment Wage WRWR WUWU SRSR D U2 D U1 E 1 = E 2 Wage Profit No increase in employment when technology is labor saving

Copyright © 2009 Pearson Addison-Wesley. All rights reserved Neocolonial Dependence Model MDCs form the “center” of global economic relations and technological advancement LDCs serving as the “periphery” are dominated by: – unequal trade and finance relations – domestic politico-economic elite – multinational corporations Under these conditions economic development is impossible

Copyright © 2009 Pearson Addison-Wesley. All rights reserved Neocolonial Dependence Model American MDCs African LDC S Latin American LDC S Asian LDC S European MDCs Other MDCs

Copyright © 2009 Pearson Addison-Wesley. All rights reserved False-Paradigm Model Economic development relies heavily on funds from international donor agencies such as the World Bank and IMF The policy of these agencies is to support urban industrial growth and impose capitalistic austerity measures They reinforce the pattern of “dependent development”

Copyright © 2009 Pearson Addison-Wesley. All rights reserved Dualistic Development Model Structural transformation models create a “dualistic” pattern of development, resulting in an ever-increasing degree of economic inequality both nationally and internationally: – urban vs. rural – industrial vs. agricultural – modern vs. traditional – rich vs. poor

Copyright © 2009 Pearson Addison-Wesley. All rights reserved Approaches to Development Free-market approach: rely of the allocation role of markets and limited government involvement in economics. But, there are several areas in which markets fail to achieve efficient outcomes: – income distribution – public goods – externalities – market power

Copyright © 2009 Pearson Addison-Wesley. All rights reserved Approaches to Development Market-friendly approach: improve market operation through “nonselective” interventions such as – income redistribution system – investment in social and human capital – environmental protection policy – anti-trust laws

Copyright © 2009 Pearson Addison-Wesley. All rights reserved Approaches to Development Public-choice approach: public officials and bureaucrats in the position of authority are “rent-seeking” citizens acting on self-interest rather than public-interest Need a system of checks and balances to monitor the behavior of public officials and bureaucrats Need a democratic system to let people choose public officials and bureaucrats for limited duration of authority

Copyright © 2009 Pearson Addison-Wesley. All rights reserved Capital Formation – Physical capital formation: investment in tools, equipment, machinery, buildings – Social capital formation: investment in roads, dams, airports, railroads, bridges – Human capital formation: investment in education, training, health, nutrition – Political capital formation: investment is creating a secular and democratic government and free mass media Appendix 3.1: Components of Economic Growth

Copyright © 2009 Pearson Addison-Wesley. All rights reserved Determinants of Economic Growth Physical Capital Formation – Increase in the amount of physical capital per unit of labor

Copyright © 2009 Pearson Addison-Wesley. All rights reserved Determinants of Economic Growth Technological Advancement – Increase factor productivity (labor, land, capital)

Copyright © 2009 Pearson Addison-Wesley. All rights reserved Production Possibilities Curve Maximum quantities of two good and services the economy can produce, assuming: – full employment / efficiency – fixed resources – constant technology

Copyright © 2009 Pearson Addison-Wesley. All rights reserved PPC Schedule Combination Radios Rice A BCE

Copyright © 2009 Pearson Addison-Wesley. All rights reserved Rice A B C E D PPC Graph F Radios Combinations A, B, C, and E are attainable Combination D is unattainable given resources and technology Combination F is attainable, but inefficient

Copyright © 2009 Pearson Addison-Wesley. All rights reserved Economic Growth Rice A B C E D Radios Combination D becomes available with more resources and better technology

Copyright © 2009 Pearson Addison-Wesley. All rights reserved Rice A B C E Economic Improvement F Radios Combinations G (or B or C) becomes efficient with more employment and/or improved efficiency G

Copyright © 2009 Pearson Addison-Wesley. All rights reserved Technological Advancement Rice Radios Neutral: proportional increase in the supply of Rice and Radios

Copyright © 2009 Pearson Addison-Wesley. All rights reserved Technological Advancement Rice Radios Capital augmenting: greater increase in the supply of Radios

Copyright © 2009 Pearson Addison-Wesley. All rights reserved Technological Advancement Rice Radios Labor augmenting: greater increase in the supply of Rice

Copyright © 2009 Pearson Addison-Wesley. All rights reserved Technological Advancement Rice Radios Advancement only in agricultural production

Copyright © 2009 Pearson Addison-Wesley. All rights reserved Technological Advancement Rice Radios Advancement only in industrial production

Copyright © 2009 Pearson Addison-Wesley. All rights reserved Factor Accumulation Accounts for Only a Fraction of Growth