Economic Development Theory

The real differences are not quantitative, but qualitative.  Egypt's inability to raise its
standard of living has more to do with its social, political, and economic institutions and
with its perceptions of past, present, and future than with any lack of effort or personal
talents"  Fred Gottheil, Principles of Macroeconomics 3e, p. 426.

the stages of economic growth

The Stages of Growth: A Non-Communist Manifesto, Walt Whitman Rostow, 1960.

The theory is intended as a direct counter to the Marxist stage theory of capitalist
development.  The basic proposition is that all countries are located in one of a
hierarchy of developmental stages:

1. traditional society
2. transitional stage: the preconditions for take-off
3. take-off
4. drive to maturity
5. high mass consumption

In stages four and five nations achieve stable conditions for self-sustaining growth and
wealth creation.  This notion presents a direct challenge to the Marxist argument of a
violent end to the capitalist system.

The launching platform for development is in the preconditions stage.

 Agriculture moves more toward market orientation in which food and raw
materials become available to other sectors of the economy.  The agricultural
sector develops beyond subsistence with production for the market.
 Transportation and other social infrastructure develop.
 Export expansion is necessary in order to finance the increased capital imports
needed for a strong foundation for economic growth.

The critical stage is the take-off stage.  At this time the rate of investment increases
sharply.  Leading economic sectors emerge and create investment opportunities in
other parts of the economy.  This ensures the self-sustained growth of the drive to
maturity and high mass consumption stages.

Harrod-Domar Growth model

Harrod, R. F. (1939), "An Essay in Dynamic Theory," Economic Journal, Vol. 49, No. 1.

Domar, D. (1946), "Capital Expansion, Rate of Growth and Employment,"

Econometrica, Vol. 14.
Neither of the articles was concerned with developing countries.  Each dealt with
conditions for stable growth in more developed countries.  Nevertheless the articles
have had a great impact on economic development theory.

Assume:

1. Aggregate demand and supply would be in balance when investment (I t) in any

period equaled the change in national income (Y t -Yt-1) times the capital to output
ratio (k).  The capital to output ratio indicates the value of capital required to
produce one unit of output in a single time period.
2. At equilibrium in a closed economy intended investment would equal intended
savings (St), which gives the initial equilibrium condition.

The rate of growth is determined jointly by the national savings ratio and
national capital to output ratio.  The more a nation can save and invest the
quicker it can grow!
    e.g. assume k = 3, s = 6%

    but, if one can increase national savings from 6% to 15%

This helped Rostow to define the "take-off" stage.  If a country could just save 15% to
20% it could develop and grow at a much faster rate than those who saved less.  This
growth would be self-sustaining.

The primary policy implication is that the needed investment resources could be met
through foreign aid.
 

Study Question:
Describe the Harrod-Domar Growth Model including equations and policy implications.

two-gap model

The two-gap model is an extension of the Harrod-Domar growth model.  The second
"gap" (in addition to the savings gap)  is found by introducing foreign trade and
rephrasing the model such that:

savings gap -- domestic savings are inadequate to support the level of growth which
could be permitted given the import purchasing power of the economy and the level of
other resources

foreign exchange gap -- import purchasing power conferred by the value of exports plus
capital transfers may be inadequate to support the level of growth permitted by the level
of domestic saving

The two-gap theory purports that investment and development are restricted by level of
either domestic saving or import purchase capacity

the big push/balanced growth

Rosenstien-Rodan, Paul N., "Problems of Industrialization of Eastern and Southeastern

Europe," Economic Journal (June - Sept. 1943), p. 202-211.
  Industrialization is "the way of achieving a more equal distribution of income
between different areas of the world by raising incomes in depressed area at a
higher rate than in rich areas."
 Use more capital in both agricultural and non-agricultural sectors, but the stress
was on the industrial sectors.
 Rejects the Rostowian view that development proceeds from more to less
developed areas.
 The "big push" was needed because industrial firms were more capital intensive.
 The big push was to develop industry and not agriculture, although agriculture
could not be ignored.  This was the way to break the vicious circle of poverty!
 Establish large number of factories, each producing a different product.  This
would include all factory workers as well as initial buyers because supply would
not create its own demand.
 Firms would be profitable.  One big push would assure there would be a
sufficient market for incentive to invest.
 The big push would create external economies (services such as warehousing,
deliveries, cleaning, and security) which would provide cost reductions to an
individual firm that was made possible by the proximity of a large number of
firms.
 The big push -- sudden sharp increase in the rate of investment (capital
formation) required large scale government planning.   this notion took for
granted the appropriateness of capital intensive techniques.

unbalanced growth

The Strategy of Economic Development, A. O. Hirschman, Yale University Press, 1958.

Unbalanced growth recognized both backward (inputs create demand for other
products) and forward (inputs to other industries).

State support was seen as needed to initiate large-scale investment in a leading sector. 
This would create the necessary external economies to induce supplying and client
industries which would in turn stimulate a secondary wave of investment and
entreprenuership.

On Big Push Theory

A. The Basic Idea
Rosenstein and Rodan (1943, 1961) argue that
“coordinated investment” is
the basis of the concept of the big push. When many
sectors have
simultaneously adopted increasing returns
technologies, they would all
create income as well as demand for goods in other
forward and backward
linked sectors. Such income creation and demand
enhancement would then
enlarge the market, leading to industrialization.
B. A Simple Illustrative Model: Murphy-Shleifer-
Vishny (1989)
• Main contribution: to formalize the demand
spillovers
• Preference: log-linear over a continuum of goods xi:
U 1ln(x )di
= ∫0 i
• Production:
o traditional technology (m sectors): constant returns
– each unit of
labor produces one unit of output (cottage production,
zero profit)
o modern technology (n sectors): increasing returns –
upon paying a
fixed amount of labor input F, the monopolist in each
sector turns
each additional unit of labor into α unit of output
• Profit of each increasing returns sector: by taking
labor as numeraire
(wage = 1), y F y F
a
a1−=μ−⎟
⎠
⎞
⎜⎝
⎛−
π = , where μ is the markup
• Aggregate profit: Π = n(μy − F)
• Budget constraint: D = y = П + L, which can be
combined with the
profit function to yield, (L Fn)
1n
y1⎟−
⎠
⎞
⎜⎝
⎛
−μ
=
o L − Fn is total labor used in production (rather
than fixed cost
investment in the modern sector technology)
o 1n
1
−μ
is the multiplier, increasing in n and exceeding one due
to
increasing returns
• Demand spillovers: the more firms are in the modern
sector (n higher),
the larger is the multiplier and the higher is the
aggregate demand (D
higher) – when goods are normal, higher income and
aggregate
demand will raise demand for goods in all sectors,
which will in turn
make additional traditional firms switch to the
modern sector
• To have enough mass n in the modern sector
requires a big push.