1. EC348 Development Economics
Chapter 3 Lecture – Classic Theories of Economic Growth and Development
Opera House, Hanoi
*Dennis C. McCornac

2. Models of Development 3-2
If we can understand how development occurs, strategies
can be adopted to help countries to develop
(adopted from Biz/ed
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3. Rostow - Stages of Growth
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4. Rostow - Stages of Growth
The work of American Walt W. Rostow
Rostow is an economic historian
Countries can be placed in one of five categories in terms of its stage of growth:
A child in Sierra Leone making breakfast. Which stage would a country like Sierra Leone fit in?
Copyright: Dave Dyett,
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5. Rostow - Stages of Growth
1. Traditional Society
Characterised by
subsistence economy – output not traded or recorded
existence of barter
high levels of agriculture and labour intensive agriculture
2. Pre-conditions:
Development of mining industries
Increase in capital use in agriculture
Necessity of external funding
Some growth in savings and investment
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6. Rostow - Stages of Growth
3. Take off:
Increasing industrialisation
Further growth in savings and investment
Some regional growth
Number employed in agriculture declines
4. Drive to Maturity:
Growth becomes self-sustaining – wealth generation enables further investment in value adding industry and development
Industry more diversified
Increase in levels of technology utilised
At this stage, industrial growth may be linked to primary industries. The level of technology required will be low
As the economy matures, technology plays an increasing role in developing high value added
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7. Rostow - Stages of Growth
5. High mass consumption
High output levels
Mass consumption of consumer durables
High proportion of employment in service sector
Service industry dominates the economy – banking, insurance, finance, marketing, entertainment, leisure and so on.
Copyright: Elliott Tompkins,
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8. Criticisms Too simplistic
Necessity of a financial infrastructure to channel any savings that are made into investment
Will such investment yield growth? Not necessarily
Need for other infrastructure – human resources (education), roads, rail, communications networks
Efficiency of use of investment – in palaces or productive activities?
Rostow argued economies would learn from one another and reduce the time taken to develop – has this happened?
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9. Market Based
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10. Market Based Problems 3-10
Development is determined by the extent to which the market is able to allocate resources
The price signal acts to allocate scarce resources
Governments limit interference in the working of the economy
Government role is to encourage enterprise and to reduce regulation and inefficiencies in free markets and establish ownership of property rights
Problems
Existence of market failure – externalities, monopoly power, public goods
Problems of lack of infrastructure – education and health, public transport, legal structure
Problems of equity in allocation – wealth and income distribution
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11. International Dependence or Dependency Theory
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12. International Dependence
International division of labour – rich in high value activity, poor in low value, can be traced back to colonial and imperial dominance
Dominance of political decision making in the hands of a few wealthy and powerful groups who aim to maintain the status quo
Such interest groups also exercise power over international institutions and initiatives such as World Trade Organisation, International Monetary Fund, Kyoto talks, etc.
Advice given to poorer nations has been poor – e.g. lending to less developed countries, investment advice, etc.
Inability to solve the debt crisis and protectionism continues to prevent development of poorest countries
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13. Criticism Offers causes but no solutions 3-13
Talks to free up trade have been going on for many years, progress is slow.
We know that protectionism is disadvantageous to developing countries but how do we go about putting in place solutions to help solve the problem?
Copyright: Doug Wray,
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14. Structural Change
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15. 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 (lower the better)
Write ΔK = kΔY or I = kΔY
From S = I, write sY = kΔY or
ΔY/Y = s/k
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16. 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%
GDP growth rate = s/k
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17. The Solow Model
Due to Robert Solow, who won Nobel Prize for contributions to the study of economic growth
A major paradigm:
widely used in policy making
benchmark against which most recent growth theories are compared
Looks at the determinants of economic growth and the standard of living in the long run
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18. Basic Model
1. K (capital) is variable: investment causes it to grow, depreciation causes it to shrink
L is no longer fixed: population growth causes it to grow
Consumption function is simple
No G or T (only to simplify presentation; we can still do fiscal policy experiments)

19. The Production Function
In aggregate terms: Y = F (K, L)
Define: y = Y/L = output per worker
k = K/L = capital per worker
Assume constant returns to scale: zY = F (zK, zL ) for any z > 0
Pick z = 1/L. Then
Y/L = F (K/L, 1)
y = F (k, 1)
y = f(k) where f(k) = F(k, 1)

20. The Production Function
Output per worker, y
Capital per worker, k
f(k) 1
MPK = f(k +1) – f(k)
Note: this production function exhibits diminishing MPK.

21. The National Income Identity
Y = C + I (remember, no G )
In “per worker” terms: y = c + i where c = C/L and i = I /L
The Consumption Function
S = savings and s = the saving rate, the fraction of income that is saved (s is an exogenous parameter)
Note: s is the only lowercase variable that is not equal to its uppercase version divided by L
S = sY
Consumption function: c = (1–s)y (per worker)
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22. Saving and Investment c = (1–s)y and we know S = I
Since we know Y = C + I = C + S then S = Y – C
or sY = Y - C
We define
Saving (per worker) = S/L = y – c
S/L = y – (1–s)y = y – y + sy = sy
sY/L = sy = y – c
National income identity is y = c + i
Rearrange to get: i = y – c = sy (investment = saving)
Using the results above, i = sy = sf(k)

23. Output, Consumption, and Investment
Output per worker, y
Capital per worker, k
f(k) y1 k1 c1
sf(k) i1

24. Depreciation δ= the rate of depreciation
= the fraction of the capital stock that wears out each period
Depreciation per worker, δ k
Capital per worker, k
δ k δ 1

25. k = s f(k) – δk Capital Accumulation
The basic idea: Investment increases the capital stock, depreciation reduces it.
Change in capital stock = investment – depreciation
 k = i – δk
Since i = sf(k) , this becomes:
k = s f(k) – δk

26. The Equation of Motion for k
k = s f(k) – δk
The Solow model’s central equation
Determines behavior of capital over time…
…which, in turn, determines behavior of all of the other endogenous variables because they all depend on k. E.g.,
income per person: y = f(k)
consumption per person: c = (1–s) f(k)

27. k = s f(k) – δk The Steady State
If investment is just enough to cover depreciation [sf(k) = δ k ], then capital per worker will remain constant:  k = 0.
This occurs at one value of k, denoted k*, called the steady state capital stock.

28. Investment and depreciation
The Steady State
Summary: As long as k < k*, investment will exceed depreciation, and k will continue to grow toward k*.
Investment and depreciation
Capital per worker, k k
sf(k) k*

29. Important Extensions Population growth Improvements in Technology
Acts like depreciation and lowers the standard of living
Improvements in Technology
Lead to sustained growth over time
Human Capital
Can stop convergence in standards of living across countries

30. Explaining the Sources of Growth
Try to decompose the growth in income into growth in labor, growth in the capital stock, and growth in productivity
It is a somewhat mechanical exercise, but an interesting descriptive tool
Assume the following production function: Y = AF(K,L)
“A” represents the technological level, usually called Total Factor Productivity
We want to decompose the changes in Y into changes in A, K, and L
Decomposition of the Growth in Income
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31. Decomposition of the Growth in Income - Result
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32. Expression allows one to decompose the changes in Y, and, besides, to estimate the changes in “Total Factor Productivity”
We can estimate shifts in the production function due to greater efficiency in the use of inputs
We only need data readily available to do that: income, capital, and labor growth rates, and wages and interest rates
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33. Example
Imagine an economy that grew at 5% in a given year, when capital stock grew by 7%, and the labor force grew by 2%.
In that same year, the share of labor income in total output was 60%, and the share of capital income was 40%.
We could estimate the growth in productivity as:
a = gy – ωK.gK – ωL.gL
a = 0.05 – 0.4x(0.07) – 0.6x(0.02) = 0.01 = 1%
TFP accounts for 1/5 of the growth in Y
Word of caution: “A” actually includes a span of different factors, and also measurement error in other variables. Things that will end up captured in “A” may be related to government policies, technological improvements, corruption, more intense use of existing inputs, etc. Indeed, “A” summarizes everything that we don’t know about.

34. 3-34
Todaro and Snilth, Economic Development Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

35. Structural-Change Models
Explanation for Increased Industry and Decline in Agriculture Share (I)
Engel’s Law: As incomes rise, the proportion of an individual’s budget spent on food declines (Ernst Engel, 19th century).
Main function of agricultural sector is to produce food  demand for agricultural products doesn’t grow as rapidly as demand for other goods (industrial products and services)
Therefore, the share of agriculture on national product declines
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36. Structural-Change Models
Explanation for Increased Industry and Decline in Agriculture Share (II)
Productivity of the agricultural sector has risen as growth progressed
That is actually the only reason why we’re able to have people employed in other (non-food producing) activities; in the beginning of human civilization, all time and labor was devoted to food production (“hunting and gathering”)
Because productivity is higher, a smaller number in agriculture can feed most of the population
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37. Figure 3.1 The Lewis Model of Modern-Sector Growth in a Two-Sector Surplus-Labor Economy
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38. Criticisms of the Lewis Model
Rate of labor transfer and employment creation may not be proportional to rate of modern-sector capital accumulation
Surplus labor in rural areas and full employment in urban?
Institutional factors?
Assumption of diminishing returns in modern industrial sector

39. Figure 3.2 The Lewis Model Modified by Laborsaving Capital Accumulation: Employment Implications

40. Why Do Industrialization and Cities Grow Together?
Economies of scale for some industrial sectors  output per unit of input rises as size of the firm rises
Different kinds of industries want to locate together, so that they can use same support facilities and infrastructure (power stations, transportation, wholesalers); “public good” aspect of infrastructure
There’s a tendency towards agglomeration in industrial activity
Also there’s a reinforcement: the larger the number of people living in cities, the higher the demand for industrial products (they do not produce their own food, clothing, etc)
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41. Division of Labor and Cities
More generally, since the middle ages, cities tend to be associated with the division of labor
When a single person is not responsible for all production, there’s an advantage associated with being located close to other people  You can sell your chickens and by clothes, soap, corn, etc
Industrialization tends to increase division of labor  increases the return to urban life
This increased urbanization can become problematic. Why?
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42. 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
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”
The so-called experts don’t really know anything but they keep trying to help anyway, making the situation worse. They are “assisted” by the local elites who have been trained at Western educational institutions and who believe all that bunk. The main problem with the policy prescriptions is that they overlook:
traditional social structures
highly unequal ownership of land
disproportionate control by elites of financial assets and access to credit

43. 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
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

44. 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

45. Appendix 3.1: Components of Economic Growth
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

46. PPC Graph Example Capital A 100 B D 90 C 50 F E 40 80 100 Consumption
Combinations A, B, C, and E are attainable
Combination D is unattainable given resources and technology
Combination F is attainable, but inefficient
Capital
Combination D becomes available with
more resources and better technology A
100 B D 90 C
We can show technological advancement and various types of growth 50 F E 40 80
100
Consumption

47. Concepts for Review Dualism Autarky False-paradigm model
Free market
Free-market analysis
Harrod-Domar growth model
Lewis two-sector model
Marginal product
Market failure
Autarky
Average product
Capital-labor ratio
Capital-output ratio
Center
Closed economy
Dependence
Dominance

48. Concepts for Review (cont’d)
Market-friendly approach
Necessary condition
Neoclassical counterrevolution
Neocolonial dependence model
Net savings ratio
New political economy approach
Open economy
Periphery
Production function
Public-choice theory
Self-sustaining growth
Solow neoclassical growth model
Stages-of-growth model of development
Structural-change theory
Structural transformation
Sufficient condition
Surplus labor