Unit I

DEVELOPMENT ECONOMICS.
Development economics or the economics of development is the application of
economic analysis to the understanding of the economies of developing countries in
Africa, Asia, and Latin America.
It is the sub discipline of economics that deals with the study of the processes that
create or prevent economic development or that result in the improvement of
incomes, human welfare, and structural transformation from a predominantly
agricultural to a more advanced industrial economy.
The subfield of development economics was born in the 1940s and 1950s but only
became firmly entrenched following the awarding of the Nobel Prize to W. Arthur
Lewis and Theodore W. Schultz in 1979. Lewis provided the impetus for and was a
prime mover in creating the sub discipline of development economics.
As a subfield concerned with "how standards of living in the population are determined
and how they change over time" (Stern), and how policy can or should be used to influence
these processes, development economics cannot be considered independently of the
historical, political, environmental, and sociocultural dimensions of the human experience.
Hence development economics is a study of the multidimensional process involving
acceleration of economic growth, the reduction of inequality, the eradication of poverty, as
well as major changes in economic and social structures, popular attitudes, and national
institutions.
Development economics covers a variety of issues, ranging from peasant agriculture to
international finance, and touches on virtually every branch in economics: micro and macro,
labor, industrial organization, public finance, resource economics, money and banking,
economic growth, international trade, etc., as well as branches in history, sociology, and
political science. It deals with the economic, social, political, and institutional framework in
which economic development takes place.
1. The study of economic development has been driven by theories of economic
development, which have developed along the lines of the classical ideas, the Marxist idea, or
a combination of both.
2. Some approaches have focused on the internal causes of development or
underdevelopment, while others have focused on external causes.
3. Economic growth increase in output and income has been used as a substitute for
development and, in some cases, has been treated as synonymous with development.
4. Economic growth and economic development have been mostly studied by means of crosscountry econometric analysis.
ECONOMIC PROBLEMS
1. Scarcity, choice and the basic economic problem
2. Opportunity costs, allocation of resources
3. Production possibility curve and productive efficiency
4. Positive and normative statements
5. Markets versus planning, free-market system, command economy
6. Economic models.
Scarcity, choice and the basic economic problem
Inflation, unemployment, pollution, energy shortages and government deficits are

some of the complex problems confronting an economy, which have an impact at the
micro level also. These problems arise due to the fact that resources are limited while
human wants are unlimited.
This leads to dissatisfaction, causing human being to look for ways to fulfill their
needs. Thus scarcity leads to the necessity of making choices. Problems of choice
arise at all levels - at the level of the individual, at the level of producers, and at the
level of the overall economy.
Scarcity results when natural resources, human resources and capital resources are
not available in sufficient quantity to satisfy all wants. So a producer has to decide
what he wants to produce using a particular resource.
For example, if he chooses to produce paper for textbooks from a stand of trees, then
no other product can be produced from that particular stand of trees. Yet, there are
many other products that could have been produced using the same natural resource,
which are also desired by consumers.
The opportunity cost of the decision thus becomes an important consideration; by
making a choice, the next best alternative good cannot be produced.
Consumers typically make their decisions based on two considerations- budget
constraints and personal preferences. A budget constraint is the difficulty a person
faces when he tries to satisfy his unlimited wants with a limited income.
Thus, a purchase decision is based on income, price, and personal tastes and
preferences. A consumer can have a choice of alternative products with a limited
income if he can find a person with whom he can exchange goods or services.
By means of such exchanges, he can increase his level of satisfaction. Such gains in
satisfaction can be termed as gains from trade.

Opportunity costs, allocation of resources

Opportunity cost can be defined as the cost of any decision measured in terms of the next
best alternative, which has been sacrificed. To illustrate the concept better, let us assume that a
person who has Rs. 100 at his disposal can spend it on any of the three options: having a dinnerat
a restaurant, going for a music concert or for a movie. The person prefers going for a dinner
rather than to the movie, and the movie over the music concert. Hence, his opportunity cost is
sacrificing the movie, the next best alternative once he goes for a dinner. If we carry forward the
same example at the firm level, a manager planning to hire a stenographer may have to give up
the idea of having an additional clerk in the accounts department. This is applicable even at the
national level where the country allocates higher defense expenditures in the budget at the cost of
using the same money for infrastructural projects. In order to maximize the value of the firm, a
manager must view costs from this perspective.
Production possibility curve and productive efficiency
Now let us analyze how individuals, producers and other economic agents use the limited
resources to meet the unlimited needs. This to a large extent is possible with the help of the
production possibility curve (PPC). The production possibility curve can be defined as a curve
which shows the maximum combination of output that the economy can produce using all the
available resources. The production possibility curve helps us understand the problem of scarcity
better, by showing what can be produced with given resources and technology. Technology is the
knowledge of how to produce goods and services.
The following assumptions are made in constructing a PPC:
The economic resources available for use in the year are fixed.
These economic resources can be used to produce two broad classes of goods.

Some inputs are better used in producing one of these classes of goods, rather than the
other.

Positive and normative statements

Another debate about the nature of economics is whether it is a positive or a
normative science. According to J. M. Keynes, A positive science may be defined as a
body of systematized knowledge concerning what is. A normative science or regulative
science is a body of systematized knowledge relating to the criteria of what ought to be and
concerned with the ideal as distinguished from the actual.....The objective of a positive
science is the establishment of uniformities; of a normative science, the determination of
ideals. Positive economics explains economic phenomena according to their causes and
effects. At the same time, it says nothing about the ends; it is not concerned with moral
judgments. On the other hand, normative economics explains how things ought to be.
According to Milton Freidman, positive economics deals with how an economic problem is
solved.
Markets versus planning, free-market system, command economy
This economic system emphasizes the freedom of individuals as consumers and
suppliers of resources, and allows market forces to determine the allocation of scarce
resources through the price mechanism. Based on market demand and supply, consumers are
free to buy goods and services of their choice and producers allocate their resources based on
the demand. Decisions made by producers and consumers are influenced greatly by price.
Price plays a major role in a market economy. The role of the government is
negligible: consumers choose the goods they want and producers allocate their
resources based on the market demand for different products.
In such a system, efficiency is achieved through the profit motive. Producers make
goods at the lowest cost of production, and consumers get higher value goods and
services at lower prices.
Command Economy In a command economy, all the economic decisions are taken by the
government what to produce, how to produce and for whom to produce. Thus, all decisions,
from the allocation of resources to the distribution of end products, is taken care off by the
government. In this type of systems, efficiency can be achieved only when demands are
accurately estimated and resources allocated accordingly. The USSR was an example of a
command economy. The government had complete control over the economy, and consumers
were just the price takers. The government set output targets for each district and factory and
allocated the necessary resources.
Economic models
Economic models are a set of equations or relationships used to summarize the working of
the national economy or of a business firm or some other economic unit. Models may
besimple or complex and they are used to illustrate a theoretical principle or to forecast
economic behavior.
Economic models can be further classified into Micro Economics Models and Macro
Economic Models.

Micro Economic Models: Models when they incorporate individual economic units
such as households and firms, often grouped into individuals markets and industries
and the relationship between them are called as micro models.
Macro Economic Models: these models are used to explain and predict the working
or performance of the economy as a whole, e.g changes in the level of NI, the level of
employment and inflation.

Different approaches in solving the above issues/problems:

Inputs (Factors of production) 1) Land, 2) Labour and 3) Capital resources.
1) Land Natural resources
2) Labour human time spent in production
3) Capital resources machines, computers, hammers, trucks, automobiles etc.,
Formulation of Societies
Market Economy or Free-market or laissez-faire economy makes decisions on an individual
level with minimal government intervention.
Planned Economy or Command Economy where all economic decisions are made by the
government (Sloman, 2001).
SOCIETYS CAPABILITIES
Takes the initiative in combining the resources of land, labour, and capital
Makes strategic business decisions
Is an innovator
Commercializes new products, new production techniques, and even new forms of business
organization
Takes risk to get profits
PRODUCTION POSSIBILITIES FRONTIER
Society uses its scare resources to produce goods and services
The alternatives and choices it faces can best be understood through macro economic model
We assume:
1. Full employment 2. Fixed Resources
3. Fixed Technology 4. Two goods
Important aspects
Use of Resources
Production Techniques
Consumption
Wants and demand
Putting the PPF to work
Before development, the nation is poor. It must devote almost all its resources to food and
enjoy few comforts
PPF provides a rigorous definition of scarcity
How societies choose among different patterns of output, how they pay for their choices,
and how they benefit or lose
PPF answers for what, how and whom.
The Production Possibilities Frontier

 Lets introduce the Production Possibilities Frontier

Better known as the PPF.
The PPF is a basic workhorse in economics.
Important for understanding some basic issues in economics.
Great application is with international trade theory.
Helps one understand and distinguish between comparative advantage and absolute
advantage.
An important historical figure in all this is David Ricardo.
David Ricardo
Famous 19th century British economist.
Some consider him the grandfather of international trade theory.
Very influential in pioneering the theory of comparative advantage, inter alia.
Very interesting, very bright guy.
Had a lot of say about the corn laws in England.
The Production Possibility Frontier - What Is It?
The description of the best possible combinations of two goods to produce using all
of the available resources.
Shows the trade-off between more of one good in terms of the other.
Assumes: input endowments given, technology given, time given and efficient
production.
Efficiency and Production Possibilities Frontier
PPF model
Shows possible combinations of 2 types of goods that can be produced when
available resources are used fully and efficiently
o Figure
Inefficient and unattainable production
o Point I and U on the curve
Shape of the PPF
o Any movement along PPF involves giving up something
Production Possibilities Frontier PPF Figure
A through F are attainable
I represents inefficient use of resources
U represents unattainable combinations
The resources in an economy are not all perfectly adaptable
Law of increasing opportunity cost each additional increment of one good requires the
economy to give up larger increments of other good
The PPF has a bowed-out shape due to the law of increasing opportunity cost
Shifts in the PPF
Economic Growth an expansion in the economy s ability to produce
Changes in resource availability
Increase (more labor) PPF shifts outward
Decrease (less resources) PPF shifts inward

 Increases in stock of capital goods

Technological change
OVERVIEW OF INTERNATIONAL TRADE THEORY
Free Trade occurs when a government does not attempt to influence, through tariffs,
quotas, or other means,
what citizens can buy from other countries or
produce and sell to other countries
The Benefits of Trade allow countries to be richer by specializing in products they can
produce most efficiently
The history of trade and government involvement presents mixed evidence
There may be some ways that some governments can make things better by intervening
But government intervening in free trade is definitely dangerous
THEORY OF ABSOLUTE ADVANTAGE
Adam Smith argued (Wealth of Nations, 1776): Capability of one country to produce more
of a product with the same amount of input than another country.
A country should produce only goods where it is most efficient, and trade (import) for
those goods where it is not efficient
Trade between countries is, therefore, beneficial
Example: Ghana/cocoa
Export those goods and services for which a country is more productive than other
countries
Import those goods and services for which other countries are more productive than it is

There may also be long-term benefits to free trade

As people specialize and seek higher incomes, they may learn to do their specialties better
COMPARATIVE ADVANTAGE:
Suppose one country is more efficient than another in everything?
There are still global gains to be made if a country specializes in products it produces
relatively more efficiently than other products
David Ricardo (Principles of Political Economy, 1817):
Efficiency of resource utilization leads to more productivity
A country should import even if country is more efficient in the products production
than country from which it is buying
Trade is a positive-sum game
Produce and export those goods and services for which it is relatively more productive than
other countries
Import those goods and services for which other countries are relatively more productive
than it is

Relations between Absolute Advantages Theory and Comparative

Advantages Theory

Your country has comparative advantage in the product or service where the ratio is
Resources required in your country Resources required in the other country is lowest
PRODUCT LIFE-CYCLE THEORY - R. VERNON (1966)
As products mature, location of both sales and optimal production changes
Affects the direction and flow of imports and exports
Globalization and integration of the economy has caused the changes in location to be
different
Technological innovation is a key determinant of trade patterns in manufactured
products.
During trade cycle, home country initially is an exporter, then loses its comparative
advantage & eventually becomes importer.
Eg. In early 1960s Xerox machine was found initially consumed in US. Exported to
Advanced countries of Europe. As demand began to grow in those countries, Xerox entered
into join ventures to produce in Japan(Fuji Xerox). Once, Xrox patents on photocopier
expired, other foreign competitors entered into market (Canon in Japan, Olivetti in Italy).
Saying Most of the new products found, produced, developed and introduced in US is
ethnocentric. Its true that it played a dominant role in global economy.
ECONOMIC EFFICIENCY
Goal
To be able to explain economic efficiency as it relates to a business.
Concepts
Efficiency
Capacity
Marketplace
Specialization

What is Economic Efficiency?

Economic Efficiency is the wise use of available resources so that costs do not exceed
benefits.
ECONOMIC GROWTH

Growth

Growth economics studies factors that explain economic growth the increase in output per
capita of a country over a long period of time. The same factors are used to explain
differences in the level of output per capita between countries, in particular why some
countries grow faster than others, and whether countries converge at the same rates of
growth.
Much-studied factors include the rate of investment, population growth, and technological
change. These are represented in theoretical and empirical forms (as in the neoclassical and
endogenous growth models) and in growth accounting.
Economic growth is an increase in the total output of the economy. It occurs when a society
acquires new resources, or when it learns to produce more using existing resources.
The main sources of economic growth are capital accumulation and technological advances.
Outward shifts of the curve represent economic growth.
An outward shift means that it is possible to increase the production of one good without
decreasing the production of the other.

From point D, the economy can choose any combination of output between F and G.

Not every sector of the economy grows at the same rate.

In this historic example, productivity increases were more dramatic for corn than for wheat
over this time period.

Capital Goods and Growth in Poor and Rich Countries

 Rich countries devote more resources to capital production than poor countries.
As more resources flow into capital production, the rate of economic growth in rich
countries increases, and so does the gap between rich and poor countries.
Economic Growth and the Gains from Trade
By specializing and engaging in trade, Colleen and Bill can move beyond their own
production possibilities.

THE ROLE OF GOVERNMENTS ECONOMIC DEVELOPMENT AND

DEVELOPMENT ECONOMICS
v Objective: transformation and economic development in undeveloped areas
v History: once succeed in past as parts of classical economics.
New opportunity:
v New cases: China, India, Russia
v New development in other areas, such as game theory, public choice and economic history
v New economists from developing countries who observe and experience the process of
development
v No institutional factors or variables in the model of mainstream, so no concerning on
institutions in development economics,
v Not to say, concerning on the system of government
v In 1950s, overlook the market system, stress on capital, and on governments, but in
distribute capital and technology rather than in supplying public goods. So no institutional
change of governments, no advantage of governments in efficiency, no labor division and
specialization in private and public goods between market and governments
v Maybe politician and elites don t like it
v In 1970s, governments failed, back to market,
v But, still no efficiency of governments, no market economy s efficiency
v No institutional change of public finance, no efficiency of governments
v The system of public finance is important, but be ignored.
v In 1990s, public finance or relationship between market and governments has been
discussed (Stiglitz, 1999) in development economics.
v Popular of new institutional school

v Uncorporate equilibrium of group game theory(Auman and Shelling)

v Public budget system be still overlooked
v How to establish or initiate a new institution
A NEW MODEL OF ECONOMIC DEVELOPMENT
v Perfectly competitive markets are defined by two primary characteristics:
(1) The goods being offered for sale are all the same, and (2) The buyers and sellers are so
numerous that no single buyer or seller can influence the market price.
Problem of mainstream model:
v The price is an exogenous variable in the function of economic growth, and a base on
which economic entities make their decisions.
v Information economics no use about information of prices, here, because consumers
always change their ideas.
Outcome:
v The efficiency of market economy missed:
v The role of entrepreneur: Guess the price of goods, even in a perfect competitive market
v The efficiency of public finance: Bargaining between taxpayers and governments for the
price of public goods
Impacts:
v The model in mainstream just concerns production, which rely on labor, capital,
technology, then innovation, but no any business
v Misunderstanding: capitalists or entrepreneurs market economy
v This misleading no influence on USA, but impact on developing countries which lack of
entrepreneurs and institutions.
What is market economy?
v Distribute resources by market system?
v Maximum of profit by mathematics?
v If so, the planner will do it best (Barro & Sala-i-Martin, 2004).
v But who knows the information in calculation?
v The advantage of market over plan: Run business and efficiency from the mechanism of
prices
v Need a institution to permit entrepreneurs to guess and bargain the price with consumers,
and governments do it with taxpayers.
Ways of economic development:
v Trade: entrepreneurs guess preferences of consumers, and raise the prices;
v Technology of trade to reduce transaction cost: invention of money;
v Institutional changes to reduce transaction cost: property right system;
v Technology of production to reduce costs: machines and organizations;
v Institutional changes in governments to reduce transaction cost: budget system;
v Capital and resources to replace labor: no save of cost, but bring us more leisure time---the objective of economic development
v All factors have been analyzed in past, but budget system.What is it? How to get it?
THE EFFICIENCY OF PUBLIC FINANCE AND THE ROLE OF GOVERNMENTS

IN SOME CASES
v Is a state or government a trouble maker (like it in SA)? Or is it a solution (like it in EA)
( Evans,1992)
v No answer just like private company, but we cannot ignored it
v The key points here are what kind of government it is, what it does as a government and
how it does those works. ----Efficiency
Efficiency of governments
v Come from the political structure or budget system
v The change of structure is slow and difficult
v East Asia rely on both of market and government----strange way
v However, not to plan or distribute resources, but to supply public goods efficiently
Three systems:
v the system to enforce laws and contracts with sovereignty,
v the system of making decisions and supervising the actions of governments by taxpayers,
v the system of showing and coordinating the preference of taxpayers on public goods and
negotiating between taxpayers and governments
The hardness of economic development
v We cannot copy a system; they are a consequence of political struggle or cooperate game.
v The system change will be influenced heavily by culture, history and old system.
v Mass democracy is not a good way; the important point is taxpayer participating in the
system. keep small group for cost and equilibrium(Olson,1980)
EXTERNALITIES Adam Smiths invisible hand of the marketplace leads selfinterested buyers and sellers in a market to maximize the total benefit that society can derive
from a market.
1. An externality refers to the uncompensated impact of one persons actions on the
wellbeing of a bystander.
2. Externalities cause markets to be inefficient, and thus fail to maximize total surplus. When
a person engages in an activity that influences the well-being of a bystander and yet neither
pays nor receives any compensation for that effect.
3. When the impact on the bystander is adverse, the externality is called a negative
externality.
4. When the impact on the bystander is beneficial, the externality is called a positive
externality.
Externality: a by-product of a transaction that affects someone not immediately involved in
the transaction.
Imply that the competitive equilibrium will not result in the social optimum
Imply that the competitive equilibrium will result in a dead weight loss
Create a role for government intervention
Negative Externalities
Automobile exhaust
Cigarette smoking
Barking dogs (loud pets)
Loud stereos in an apartment building
Positive Externalities

 Immunizations
Restored historic buildings
Research into new technologies
Negative externalities lead markets to produce a larger quantity than is socially
desirable.
Positive externalities lead markets to produce a smaller quantity than is socially desirable.
Externalities, which occur in cases where the "market does not take into account the impact
of an economic activity on outsiders." There are positive externalities and negative
externalities. Positive externalities occur in cases such as when a television program on
family health improves the public's health. Negative externalities occur in cases such as when
a companys process pollutes air or waterways. Negative externalities can be reduced by
using government regulations, taxes, or subsidies, or by using property rights to force
companies and individuals to take the impacts of their economic activity into account.
EXTERNALITIES: impacts on third parties besides the buyer and seller.
Consumption Externalities: impacts on third parties as a result of the consumption of a
good. Eg. Each infected person who takes Drugs eliminates disease helps all of society, not
Just the drug company which provides the medicine.
Production Externalities: impacts on third parties as a result of the production of a good.
Eg. New discoveries & innovations impact all of Society, not just the scientist who disovers
them and the firm who employs the Scientist (streptomyacin patent problem)
Market Power: The power of a single Company to change the price of a good or service in
the market place. Includes: MONOPOLY, MONOPOLISTIC COMPETITION, And
BILATERAL MONOPOLY. Examples: Drug Companies while they have Patents.
Inequities: any economic, social or political mechanism that systematically causes one part
of the population to be worse off than another part of a population through time without the
possibility of correction. Examples: Poor Populations have greater vulnerability to TB due to
their economic and social conditions.
Dynamic Market Failure: the failure through time to achieve technological change and the
failure of the market to achieve stable, equilibrium outcomes. Examples: As a disease
disappears in a given locale:
- lack of incentives for new drug development
- Lack of treatment for those who are diseased
Both in the area and in other areas where pandemics may occur
Indivisibilities: a problem cannot be sub- divided into smaller pieces for the purpose of
Solving the problem or marketing the solution Example: even one remaining infected person
means no cure has been achieved. Any plan to wipe out a disease means that a
comprehensive worldwide plan must be undertaken.
Information Asymmetry: decision makers do not have access to the same information
which leads to different definitions, boundaries, and solutions to problems to be solved and
social outcomes. Examples: indifference to disease, lack of education about how to treat
diseases, and failure to understand the tradeoff between private rights and public goods.