DEVELOPMENT ECONOMICS

GROWTH THEORIES

 Broadly two strata of growth theories:

 Single sector Growth Theories:

 Exogenous, Endogenous, Schumpeterian Theories.

 Act as if there is one ‘formal’ economy in which the factors of

production participate.

 Two sector Growth Theories:

 Lewis Model, Myrdal’s Cumulative Causation (discussed in dependency
theory), Kremer’s O-ring Theory, Big Push, Schumpeterian growth (fits
in both)

 Recognise the existence of a stratified economy with substantial

structural inequalities.

 Also the trouble of identifying relevant growth theories for each stage
of development (Rostow’s Stages), as well as for each country (avoiding
‘Ontological Universalism’  Components of all economies and the
interactions between them are the same for all economies).
GROWTH THEORIES
 SINGLE-SECTOR
THEORIES
 Harrod-Domar

 Model states that the rate of growth consistent with equilibrium in both input and
output markets (the Warranted Rate of Growth) is the level of savings divided by
the incremental capital output ratio (ICOR).

 Due to the assumption of fixed proportions of capital + labour, this leads to a

s knife-edge equilibrium;

gw   If the actual growth rate exceeds the warranted, then the economy will veer into

v 
inflationary pressures.

If below, the economy will accrue excess capacity and rising unemployment. BOTH
scenarios compound themselves over time.

 Thus, the Government must play a role in keeping the economy on the
equilibrium, growth follows capital accumulation (higher savings).

 BUT: the knife-edge equilibrium and unstable/difficult to calculate ICOR meant that
it is unlikely the Government would be able to put the economy on equilibrium,
and the assumption of fixed-proportions is not a realistic one.

 The Solow Growth model builds on H-D by assuming substitutability of Labour and
Capital.
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THEORIES
 The Solow Growth Model:

 Assume labour and capital are inputs to production, subject to diminishing

returns and that there is an exogenous rate of growth, competitive markets and
flexible prices.

 As shown in the diagram (see slide 6), the economy will converge to a ‘steady
state’ level of income and capital, where there is a 0 level of income per capita
growth.

 To sustain such growth, the model requires constant positive technological

shocks, constantly shifting the production function upwards.

 ‘Growth is everywhere a technological phenomenon’ - Gylfason

 Implications of the model:

 Government policies and Initial Conditions have NO LONG RUN IMPACT.

Economies at the frontier are subject to exogenous growth forces, one-time
upward shifts in savings will only have a short-run boost to growth rates.

 There is convergence between developing and developed nations with similar

fundamentals (production functions, savings rates and population growth) –
there is absolute convergence.

 Capital accumulation is, as in all neoclassical growth models, the key to growth.
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THEORIES
 The Solow Growth model has had the following criticisms levied at
it:
 Limited applicability to developing nations: the model assumes
competitive markets, but many developing nations have dualistic
markets (formal and informal sectors). There thus might be
surplus labour to draw upon at low incomes. Further, the model
assumes a balanced growth path (discussed later), which is
troublesome due to input constraints in developing nations.
 Convergence is not a ubiquitous phenomenon: Maddison (1995)
calculates that 30/43 follower countries converged on the US
1950-1989. However, there was long-run divergence driven by the
poorer countries – despite their greater ‘catch-up’ potential.
 Even if one adjusts for differences in fundamentals (Maddison
notes that convergence occurred amongst the ‘advanced
capitalist nations’ and Japan, whilst Cypher + Dietz find that the
NICs are converging on an equilibrium ahead of the advanced
capitalist nations due to higher saving/investment rates), there
are large differences in absolute income levels despite modest
differences in savings rates.
 SINGLE-SECTOR
THEORIES
Y
y k n  d 
L
y  f k
y*

sy

k* K
k
L
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THEORIES
 Exogenous Growth Theory:

 Removes the restriction of diminishing returns to all factors of

production, and places priority on the existence of increasing returns to
scale for EDUCATION and R+D.
 An educated person interacts positively with their team, leading to
positive external effects; knowledge is non-rival, thus there can be IRS
to it.

 Hence, the marginal social benefit of investment in human capital >

marginal private benefit.

 In addition, ‘learning by doing’ happens, where an individual’s

productivity rises over time, offsetting diminishing returns, and
instigates technological progress through increasing specialization.

 The higher the level of human capital accumulation, the greater these
effects, due to complementaries between the factors of production(see
Kremer’s O-ring theory).

 In addition to knowledge spillovers, assume that technology is expensive

to invent, but cheap to copy; this allows us to create a model of growth
with different policy prescriptions dependent on the location of the
economy.
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THEORIES
 Endogenous growth models typically reinforce a notion of ‘Path Dependency’:

 A country’s future performance is determined by its current performance.

 Lucas (1988) noted that an economy with low levels of human capital will have a growth
level permanently below an economy with higher levels.

 Therefore, the model actually suggest that there will be long-run divergence, as opposed to
convergence.

 Further, models reinforce Myrdal’s concept of ‘cumulative causation’; those that

accumulate more will get greater benefits due to larger spillovers; those that fail to
accumulate will be locked within a low-level equilibrium trap.

 These two aspects of endogenous growth theory (divergence and multiple equilibria) can be
seen in the diagrams on the next slide:

 The first one is the simple AK model, where technological change is a function of capital
accumulation (where human and physical capital embodies new techniques and ways of
doing things). The production function is a ray from the origin, with savings being a constant
fraction. Thus, economies will continuously move to higher levels of income per capita at
higher growth rates as the two rays diverge. Thus, a country with higher levels of capital will
always be ahead of a country with lower levels of capital.

 The second is presented by Easterly (1998). With increasing returns to scale (an upward-
sloping marginal product of capital) and a constant discount rate, there is some threshold
level of capital accumulation below which vicious cycles occur, above which, virtuous cycles
occur, with ever increasing growth.
 SINGLE-SECTOR
THEORIES

Y
y
L y  ak
MPK

sa Discount Rate

K
K k
k L
L
Endogenous Growth 1: Long-run Endogenous Growth 2: Multiple
Divergence due to spillovers. equilibria due to IRS.
 SINGLE-SECTOR
THEORIES
 Because of the presence of externalities, there is inevitably market failure.

 Thus, there is a role for Government in addressing this market failure by stimulating
R+D, providing popular education and amending copyright laws in order to realise the
marginal social benefit of human capital accumulation.

 Bardhan (1998) notes that a Government must be selective in mobilising scarce

resources for R+D funding; focus on export industries where spillovers are greater in
magnitude, and in industries which are less likely to receive private investment.

 Additionally, Government must play a role in preventing the economy from being stuck
in a low-level equilibrium trap, by implementing policies that promote a higher return to
capital (free trade, financial deregulation, less inhibitive taxation structures).

 In this sense, there are slightly different roles for Government depending on proximity
to the threshold; below or close to it there is a cause for ‘big push’ (described later) to
be undertaken – however, regardless of development status, the Gov. Should always
promote human + physical capital accumulation.

 However, accumulation by itself is a necessary but not sufficient condition for growth.

 In order for the spillover effects to be realised, there must be proper social conditions
for the assimilation of that new capital.

 New technology must be received by people who know how to use it, and are able to
adapt it to maximise its efficiency for their localised need. There needs to be a type of
‘adaptive entrepreneurship’.
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THEORIES
 SINGLE/DOUBLE-SECTOR
THEORIES
 Let Ait be the productivity attached to most recent tech in industry ‘i’ at time
‘t’, the first equation implies growth can be driven by creative destruction:
 A higher firm turnover means faster increases in the value of ‘Ait’.

 Pulling in the frontier; let Mu‘n’ be the rate of leading-edge innovation, let
Mu‘m’ be the rate of implementation (copying) innovation; gamma is a
parameter of how much the leading edge innovations are surpassing old tech,
and at is a parameter signifying the distance to the frontier.
 The smaller ‘a’, the farther from the frontier and the faster the rate of
growth so long as the rate of implementation innovations is high enough.
This requires Government support through the creation of institutions and
policies that facilitate such innovation (primary education, and reverse
engineering for example).

 The closer to the frontier, however, the more important is the need to
switch from copying innovations to leading-edge innovations, which
requires more tertiary education (the US is a good example of this, as
university education confers greater spillovers).

 In addition, the level of savings impacts on growth via implementation

innovations. FDI + imported tech embody technology from the frontier, and a
higher rate of both those will impact positively on implementation innovation
growth and therefore absolute growth for the catching up country.
 SINGLE/DOUBLE-SECTOR
THEORIES

1 
Yit  Ait K it
CREATIVE DESTRUCTION


g t   n    1   m a  11
it 
Advantages of Backwardness
DOUBLE-SECTOR
THEORIES
 DOUBLE-SECTOR
THEORIES
Output/Revenue/ Modern
Cost Prod. F’n.
W3
W2
Q2 B
W1
C2
Traditional
A Prod. F’n.
Q1
C1

F L’ L/N Labour Supply

 DOUBLE-SECTOR
THEORIES
 Kremer’s O-Ring Theory:


 Assume that there are ‘n’ tasks in a production process and that you can define
individuals by their skill level, ‘q’ (where ‘q’ is the probability of completing a task, and
lies between 0 and 1).
Example:
 The theory suggests that there will be POSITIVE ASSORTITATIVE MATCHING:
2 Skill Levels : q H , q L
 People of similar skill levels will work together.
4 Workers, 2 of each.
 Everyone wants to work with the higher productivity individual as it raises the group
output. A firm with higher skilled persons can also afford to employ higher skills,
thus it is likely that similar skills will band together.
Output is always higher if
 Implies that : they band together;
 Workers performing the same task earn more in a high-skill firm.  qH2  qL2  2qH q L
 qH  qL   0
 Multiple equilibria with low and high quality persons. 2

 Cumulative Causation: When those around you have higher average skills, you have
an incentive to invest in human capital, when faced with bottlenecks in low-
productivity firms, it reduces the incentive to invest in skills.

 Trade can ameliorate the bottlenecks by increasing the supply of inputs.

 International Brain Drain.

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THEORIES
 DOUBLE-SECTOR
THEORIES
Wage Lewis’ model does however
predict substantial
inequalities.
A vastly rich capitalist class will
emerge, with a middle class
urban labourer. However, a gap
emerges between the
agricultural and industrial
labourer so long as there is a
difference between the two
wages.
Thus, in the short run, one could
argue that agricultural workers
are exploited. However, as
Capitalists’ MPL MPL’ Robinson argued:
Share “The misery of being exploited is
Industrial Wage nothing compared to not being
exploited at all.”

Workers’ 2 Main criticisms:

Share Agricultural Wage •Ignores institutional factors that
influence wages in the industrial
sector (labour unions), which
reduces the absorptive capacity
of the sector.

•Questionable assumption that

L L’ Labour capitalist will reinvest profits,
rather than engage in capital
flight (as happened in 1980s).
DOUBLE-SECTOR
THEORIES
 DOUBLE-SECTOR
THEORIES
MRPa M MRPm
q

A
Wm

M
Wa A
q
0a Z La Lm 0m
Urban
unemployment
CONCLUSION
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