Quiambao, Chaps Vince O.

BSBA-II

Theories of Economic Development

What is Economic Development?

Economic Development occurs with the reduction and elimination of poverty, inequality and unemployment within a growing economy.

Gini coefficient This is a statistical measure of income distribution. A Gini coefficient of 0 means perfect equality.

Human Development Index (HDI) Measures a country's average achievements in three basic dimensions of human development: life
expectancy, educational attainment and adjusted real income (PPP$ per person).

What do theories and models try to do?

Economic development theories and models seek to explain and predict how:
Economies develop (or not) over time
Barriers to growth can be identified and overcome
Government can induce (start), sustain and accelerate growth with appropriate development polices

Theories are generalizations. While Less Developed Countries (LDCs) share similarities, every country’s unique economic, social, cultural,
and historical experience means the implications of a given theory vary widely from country to country.

There is no one agreed “model of development”. Each theory gives an insight into one or two dimensions of the complex process of
development. For example, the Rostow model helps us to think about the stages of development LDCs might take, while the Harrod-Domar
model explains the importance of adequate savings in that process.

Economic Development Concepts:

Absolute advantage Occurs when a country or region can create more of a product with the same factor inputs.

Comparative advantage The basis of standard free trade theory. First introduced by David Ricardo in 1817. Ricardo predicts all countries
gain if they specialize and trade the goods in which they have a comparative advantage. Comparative advantage exists when a country has a
margin of superiority in the production of a good or service i.e. where the opportunity cost of production is lower. This is true even if one of
the trading nations is more productive in all traded goods (has an absolute advantage) compared to the other country.

The Rostow Linear Stages Model

This is a linear theory of development. It argues that to achieve ?modernity? all countries pass through the same stages of development
Economies can be divided into primary, secondary, and tertiary sectors. The history of developed countries suggests a common pattern of
structural change:

The Harrod-Domar Savings Model The Harrod-Domar model developed in the l930s suggests that a population’s savings provide the
funds, which are borrowed for investment purposes. Higher rates of savings can be transferred into higher rates of investment to generate
self-sustaining economic growth.

The Lewis Dual Sector Model The Lewis model is structural change model that explains how labor transfers in a dual economy. For Lewis
growth of the industrial sector drives economic growth.

The Solow Growth Model Economic growth is depends on the quantity and quality of resources and technology.

Dependency Theory Dependency refers to over reliance on another nation. Dependency theory uses political and economic theory to
explain how the process of international trade and domestic development makes some LDCs ever more economically dependent on
developed countries

Balanced Growth Theory Balanced growth (or the big push) theory argues that as a large number of industries develop simultaneously,
each generates a market for one another.

Unbalanced Growth Theory Unbalanced growth theorists argue that sufficient resources cannot be mobilized by government to promote
widespread, coordinated investments in all industries. Therefore, government planning or market intervention is required in a few strategic
industries. Those with the greatest number of backward and forward links to other industries are prioritized.

The Tobin Tax on foreign exchange transactions to reduce speculation and raise revenue for development

The Trickle Down Theory Here the initial benefits of growth go the rich, but eventually trickle down to the poor. For example, rich families
buy local produce and employ servants, etc
The Washington Consensus A set of liberalization polices advocated by free market economists to encourage growth.

Major Economic Development Models

Rostow

This is a linear theory of development. Economies can be divided into primary secondary and tertiary sectors. The history of developed
countries suggests a common pattern of structural change:

Stage 1 - Traditional Society:

Characterized by subsistence economic activity i.e. output is consumed by producers rather than traded, but is consumed by those who
produce it; trade by barter where goods are exchanged they are 'swapped'; Agriculture is the most important industry and production is labor
intensive, using only limited quantities of capital.

Stage 2 - Transitional Stage:

The precondition for takeoff. Surpluses for trading emerge supported by an emerging transport infrastructure. Savings and investment grow.
Entrepreneurs emerge.

Stage 3 - Take Off:

Industrialization increases, with workers switching form the land to manufacturing. Growth is concentrated in a few regions of the country
and in one or two industries. New political and social institutions evolve to support industrialization.

Stage 4 - Drive to “Maturity”

Growth is now diverse supported by technological innovation.

Stage 5 - High Mass Consumption

Implications of Rostow's model

Development requires substantial investment in capital equipment; to foster growth in developing nations the right conditions for such
investment would have to be created i.e. the economy needs to have reached stage 2.

For Rostow:

Savings and capital formation (accumulation) are central to the process of growth hence development.

The key to development is to mobilize savings to generate the investment to set in motion self generating economic growth.

Development can stall at stage 3 for lack of savings – 15-20% of GDP required. If the domestic Savings rate is 5%, then international
aid/loan must total 10-15% in order to plug the ‘savings gap’. Resultant investment means a move to stage 4 Drive to Maturity and self-
generating economic growth

Limitations of Rostow's Model

Rostow's model is limited. The determinants of a country's stage of economic development are usually seen in broader terms i.e. dependent
on:

the quality and quantity of resources

a country's technologies
a countries institutional structures e.g. law of contract

Rostow explains the development experience of Western countries, well. However, Rostow does not explain the experience of countries
with different cultures and traditions e.g. Sub Sahara countries which have experienced little economic development.

Introduction to the Harrod-Domar model

The Harrod-Domar model developed in the l930s suggests savings provide the funds, which are borrowed for investment purposes.

The economy's rate of growth depends on:

the level of saving and the savings ratio

the productivity of investment i.e. economy's capital-output ratio

For example, if £8 worth of capital equipment produces each £1 of annual output, a capital-output ratio of 8 to 1 exists. A 3 to 1 ratio
indicates that only £3 of capital is required to produce each £1 of output annually.

Further Analysis

The Harrod-Domar model developed in the 1930’s to analyze business cycles. it was later adapted to ‘explain’ economic growth.

Economic growth depends on the amount of labor and capital i.e. ?NY = f(K,L)

Developing countries have an abundant supply of labor. So it is a lack of physical capital that holds back economic growth hence
economic development.

More physical capital generates economic growth. (use Production Possibility Boundaries to illustrate)

Net investment (i.e. investment over and above that needed to replace worn out capital (deprecation) leads to more producer
goods (capital appreciation) which generates higher output and income. Higher income allows higher levels of saving

Implications of the Harrod Domar Model

Economic growth requires policies that encourage saving and/or generate technological advances, which lower capital-output ratio.

Criticisms of the model

Domar on Domar: My purpose was to comment on business cycles, not to derive "an empirically meaningful rate of growth."

It is difficult to stimulate the desired level of domestic savings

Meeting a savings gap by borrowing form overseas causes debt repayment problems later.

Diminishing marginal returns to capital equipment exist so each successive unit of investment is less productive and the capital
to output ratio rises.

The amount of investment is just one factor affecting development e.g. supply side approach (free up markets); human resource
development (education and training)

Economic growth is a necessary but not sufficient condition for development

Sector structure of the economy important (i.e. agriculture v industry v services)

Lewis Model - An Overview

The Lewis model is structural change model that explains how labor transfers in a dual economy. For Lewis growth of the industrial sector
drives economic growth. The Lewis Model argues economic growth requires structural change in the economy whereby surplus labor in
traditional agricultural sector with low or zero marginal product, migrate to the modern industrial sector where high rising marginal product.

Transferring surplus labor from rural to urban areas has no effect on agricultural productivity as MP of rural workers = 0.

Firm’s profits are reinvested. Growth means jobs for surplus rural labor. Additional workers in urban areas increase output hence incomes
and profits. Extra incomes increase demand for domestic products while increased profits fund increased investment. Hence rural urban
migration offers self-generating growth.

The ability of the modern sector to absorb surplus works depends on the speed of investment and accumulation of capital. Where firms
invest in new labor saving capital equipment, surplus workers are not taken on by the formal sector. Recently arrived rural migrants join the
informal economy and live in shantytowns

Given urban growth drives economic growth it can lead to the neglect of agriculture by government

Neglect of Agriculture – yet most people live in rural areas where incomes are relatively low

Increased profits may be invested in labor saving capital rather than taking on newly arrived workers

For many LDC's, rural urban migration levels have been far greater than the formal industrial sector’s ability to provide jobs. Urban poverty
has replaced rural poverty.

Dependency theory - An Overview

Dependency refers to over reliance on another nation. Dependency theory uses political and economic theory to explain how the process of
international trade and domestic development makes some LDC's ever more economically dependent on developed countries ("DC's").

Dependency theory refers to relationships and links between developed and developing economies and regions.

Dependency theory sees underdevelopment as the result of unequal power relationships between rich developed capitalist countries and
poor developing ones.

Powerful developed countries dominate dependent powerless LDC's via the capitalist system. In the Dependency model under development
is externally induced (i.e. DC not LDC’s fault) system. Growth can only be achieved in a closed economy and pursue self-reliance through
planning.

Dominant DC's have such a technological and industrial advantage that they can ensure the ‘rules of the game’ (as set out by World Bank
and IMF) works in their own self-interest.

This partly explains the hostility shown towards the WTO in Seattle in 1999.

In this model under development is externally induced (i.e. DC not LDC’s fault) and only a break up of the world capitalist system and a
redistribution of assets (e.g. elimination of world debt) will ‘free’ LDC's

Balanced Growth Theory

Balanced growth involves the simultaneous expansion of a large number of industries in all sectors and regions of the economy. Balanced
growth (or the big push) theory argues that as a large number of industries develop simultaneously, each generates a market for one another.

If a large number of different manufacturing industries are created simultaneously then markets are created for additional output. For
example, firms producing final goods can find domestic industries that can supply them with their inputs. The benefits of growth are spread
over all sectors and, ideally, regions.

Balanced growth theory is an extension of Say’s Law the demand for one product is generated by the production of others

It is argued that free markets are unable to deliver balanced growth because entrepreneurs:

Do not expect a market for additional output – why risk resources when sales are uncertain?

Require skilled workers but are not willing to hire and train unskilled staff who may then leave to work for rival firms –
employers cannot ‘internalize their positive externalities

Do not anticipate the positive externalities generated by the investment of other firms engaged in expansion

Are unable to raise finance for projects

If government can co-ordinate simultaneous investment in many industries one firm provides a market for another. This requires state
planning and intervention to:

Train labor
Plan and organize the large-scale investment program.
Mobilize the necessary finance
Nationalize strategic industries and undertake infrastructure investments e.g. build roads
Protect infant industries through tariff (tax on imports) and quota (limit on quantity of imports) policies

The strategy of balanced growth is beyond the resources of most poor countries; Balanced growth within a closed economy rather than
specialization and trade contradicts comparative advantage

Government planning results in government failure i.e. government intervention in the market fails to bring about an efficient allocation of
resources e.g. planning process creates a bureaucracy.

LDC development policies focusing on import substitution, agricultural self-sufficiency and state control of production yield poor growth.

Unbalanced Growth Theory

Unbalanced growth theorists argue that sufficient resources cannot be mobilized by government to promote widespread, coordinated
investments in all industries.
They share analysis with balanced growth theorists that free markets, alone, cannot generate development but differ in that government
planning or market intervention is required just in strategic industries.

Those with the greatest number of backward and forward links are prioritized.

A country lacks resources to finance balanced growth. Resources are therefore concentrated on strategic industries with:

Significant forward linkages i.e. firms creating essential inputs for other key firms in the economy

Significant backward linkages i.e. key firms buy industrial inputs from a large number of domestic firms

Import substitution. Developing domestic industries replaces imports and so improves the balance of payments.

Government identifies strategically important areas with significant backward and forward linkages to
Nationalize (planned economy) or
Subsidies (market economy).

E.g. State owned development banks finance priority investment projects chosen for their contribution to growth and development goals.