Economics and Scarcity

Let’s begin by discussing scarcity. Resources (land, labor, factory buildings,

timber, minerals, machinery, and the like) are the basis for producing the food, shelter,
medical care, and luxury goods that we want. Some of these are natural resources (land
and timber), some are capital goods resources (factories and machinery) and some are
human resources (labor). These resources are scarce in the sense that there are not
enough of them to produce everything we need and desire. Even when using all
resources as efficiently and completely as possible, and using all modern technology to
its fullest extent, there is some limit to the amount we can currently produce. Scarcity
forces us to choose among competing uses for society’s resources. What to produce and
how to distribute this output to society’s citizens are the most basic economic choices to
be made.
The easiest way to think about the problem of societal choice is by looking at a basic
economic concept and graph called production possibilities. Production possibilities
shows the maximum amounts of two different goods that can, possibly be produced during
any particular time period using society’s scarce resources. Because reality is complex,
economists try to simplify it by making assumptions about the basic elements involved
in analyzing an issue. In examining production possibilities, we must make these
simplifying assumptions about our economy:

1.      All available resources are used fully.

2.      All available resources are used efficiently.
3.      The quantity and quality of available resources are not changing during our
period of analysis.
4.      Technology is not changing during our period of analysis.
5.      We can produce only two goods with our available resources and
technology.
Let’s consider the implications of these simplifying assumptions.
 First, all available resources are used fully, so that no workers are
unemployed, no factory buildings sit idle, and so forth. (This does not mean
that we fail to conserve some of our resources for the future. If we think that
the habitat of the snowy owl is important ecologically, we simply do not make
that part of the available resources.).
 Second, efficiency means that we use our knowledge and technology to
produce the maximum amount of output with these resources. These first two
assumptions mean that our economy is doing the best that it can; it is
operating fully and efficiently.
 Third, the quantity and quality of our .resources are not changing. This means
that over the current time period, workers do not begin new training programs
to make them more productive, new natural resources are not discovered,
and so on.
 Fourth, technological change-which might give us a better means of
producing more goods with the same resources-is not occurring. We make
 these last two assumptions to deal with the world as it is right now, and not
how it might become in the future. And finally, to simplify our analysis (and
because here we graph in only two dimensions), we assume that we can
produce only two goods with our resources. Let’s pick bread and roses as the
goods.
One of our choices is to put all of our resources and technology into the
production of bread. This choice might give us 150 units of bread. Whether these bread
units are loaves, cases, truckloads, or tons is irrelevant here. Let’s suppose they are
tons.
 
Two old adages suggest that man (and woman) cannot live by bread alone and
that life is richer if we stop and smell the roses. So, let’s allow another choice and take
some resources and some technology out of bread production and use them to produce
roses. Now, we might end up with 20 units of roses and only 120 tons of bread. Again,
the nature of the units is irrelevant; our rose units might be bouquets, boxes, truckloads,
or tons. Let’s suppose they are tons. (Note, however, that we had to give up 30 tons of
bread production to produce the 20 tons of roses.)
Another alternative might be to give up even more bread, leaving us with bread production of
only 90 tons, to produce 40 tons of roses. (Note that, once again, we had to give up 30 tons of
bread production to get the additional 20 tons of roses.) The alternatives could go on and on
and might be summarized in a production possibilities table such as Table 1.1. Note that each
alternative A through F represents one possible combination of bread and roses that we could
produce.
                                                          The information in Table 1.1 can be easily displayed in
a production possibilities curve, or graph. Don’t let graphs intimidate you. They can be
very useful. Every graph has just two axes, and each axis shows the amounts of one
variable. As you move along the axes away from the origin, the amounts of the
variables increase. In Figure 1.1, the horizontal axis represents tons of roses, and the
vertical axis represents tons of bread. Each point in the graph represents a row in the
table, and the labelling of the points corresponds to the alternatives in the table.
Connecting all points gives us a production possibilities curve, which shows the
alternative combinations of maximum quantities of bread and roses that our country is
capable of producing. (Even though we end up with a straight line, we still call it a
production possibilities curve).
A number of important concepts are illustrated by the production possibilities curve. These are the
following:
             
Note: the handwritten reads this way:
 There is some limit to what we can produce.
 to produce more of one good, we must give up production of something else.
 Opportunity cost is the best alternative that is forgone to produce or consume
something else.
“There is an opportunity cost to everything”.
The opportunity cost of producing roses is not measured in dollars but in the bread that
we give up when we produce these roses. And the opportunity cost of producing bread
is the roses we give up when we produce this bread. As economists are fond of saying,
there is no free lunch! 
Unemployment  - In reality, some resources may go unused: factories are idle
and workers are laid off. Nor do we always use resources in the most efficient manner.
In these cases, we will not be on the production possibilities curve, but at some
point below it, such as U (representing unemployment) in Figure 1.1. At point U,
we are producing only 40 tons of roses and 60 tons of bread, though we could
produce more of both if we had full employment. Clearly, we could do much
better by putting idle resources to work and moving our way back out to the
production possibilities curve.
Economic growth - occurs if the quality or quantity of society’s resources
increases
 Our country need not be restricted to a single production possibilities curve
forever. Economies may grow and the resources certainly do change over time.
Such a shift would enable us to move to a point such as point G (representing
growth) on the new production possibilities curve. Clearly, point G (with 80 tons of
roses and 90 tons of bread) is superior to a point such as D (with 60 tons of roses
and only 60 tons of bread) on the original curve. Such growth is possible only over
time, and not in the current time period illustrated by the first production possibilities
curve.
Of course, our country and world are capable of producing more than just two
goods. We produce trucks, spaghetti, gasoline, smart phones, swimming suits, and
a bewildering array of merchandise that fills our shopping centers. We also produce
services such as health care, education, road repair, and cellular phone service. We
can easily imagine infinite combinations of all the goods and services that an
economy can potentially produce. We cannot graph these infinite combinations,
however, because our graphs have only two axes. So, bread and roses simply
represent one of an infinite set of choices. We can make our graph a bit more
realistic by redefining the axes. We might redefine the horizontal axis as staple
goods and the vertical axis as luxury goods. Or we could divide our economy’s
output into agricultural goods and manufactured goods, or consumer goods (goods
that are purchased by consumers) and capital goods (goods such as factory
buildings and machinery that are used to produce other goods). We may examine
the choice between military goods and civilian ' goods. Or we may look at the
production possibilities for private goods (such as cell phones and hamburgers,
which are provided by businesses) and public goods (such as police and the
 protection, which are provided by government). Thus, we can realistically consider
many choices involved in the production of various types of output.
The production possibilities curve also helps us realize that the costs of
unemployment are not limited to personal hardships experienced by the unemployed
person and his or her family, although these personal costs may be severe. Costs
are also borne by our nation and our world as a whole 1n the form of reduced
production. If we waste our resources through inefficient production techniques,
output is similarly reduced. In a world of scarcity, we must see to it that our
resources are fully and efficiently employed in the present, and we can then seek to
expand our productive potential in the future.
And the problem of scarcity is real. Worldwide, more than 22,000 children die
every day from poverty-related causes. Many of the world’s citizens lack basic
nutrition, health .care, education, shelter; clothing, clean water, and hygiene. Many
of the world’s nations lack basic infrastructure in the form of communications,
transportation, sanitation, and electricity. Any time a poor country makes a decision
to improve transportation, for example, as an investment in the future, many of its
citizens may die of hunger in the present. Even in a prosperous country, some 15
percent of the population is poor. As we shall see in later chapters, these people do
not receive adequate food, shelter, health care, clothing, and other necessities.
 
Economics and Distribution
Although production choices are important, they really tell us only half of the
story. At least as important are choices relating to the distribution of goods and services.
The reason there is hunger in a world of plenty is not a problem of production but of
distribution. Poor people and poor governments lack the income to purchase the food
that is produced. In terms of our current example, who should receive the bread and
roses after they are produced? Should the decision be based on equality so that
everyone receives the same amount of every good that everyone else does? Should
people receive a share of the goods and services that is proportional t6 their
contribution to producing those goods and services? Should the government make the
distribution decisions, perhaps giving higher rations to those most “deserving" (however
that might be determined)? Should the government ensure that all residents receive
adequate housing, health care, nutrition, and education, with less-vital goods distributed
on the basis of people’s incomes and desires? Should all goods and services be
distributed on the basis of people’s incomes? On what basis should distribution choices
be made?
As we will see, in a market-based economy such as ours, the choices of
distribution as well as production are based primarily on prices. And prices are
determined by demand and supply.
Demand and Supply
Demand
 Have you ever had to hire a tutor to help with your coursework? (I hope you
haven’t had to in economics, at least not yet!) What are some of the factors that would
determine the number of tutoring hours you would wish to purchase? Probably the
degree of difficulty of the coursework is important, and so is your income, which will
determine how much tutoring you can afford. Most likely, the price of tutoring services is
important to you as well. All other things being equal, you would probably be inclined to
purchase more tutoring service hours at $1 per hour than at $5 per hour. Most of us
tend to behave in the same way. At very high prices, we would tend to be frugal in our
use of tutoring services. We would ask more questions in class, study with a friend, or
visit the teacher during office hours (maybe bringing along an apple or two). We would
perhaps study harder (or take the consequences) rather than pay the fee for many
hours of tutoring services if the price is high. At lower prices, we would be willing and
able to purchase more hours of tutoring. Let’s focus on the price variable for a moment.
Let’s assume that you attend a large university where there are many students
who want tutors as well as many students willing and able to tutor. Suppose we
consider all your school’s students and their desire to purchase tutoring services. Let’s
assume that the time period is one week and that all factors other than price (such as
course difficulty and student income) are held constant. (Economists usually say “all
other things equal” to specify that all other factors that might influence the quantity
demanded are unchanging.)
To illustrate this example further, let’s put this information into a tabular format.
Let’s consider people’s willingness to buy tutoring services, where P stands for
alternative possible prices of tutoring services and QD (quantity demanded) stands for
the amounts of tutoring that students are willing and able to purchase at these various
prices. This is reflected in Table 1.2, which shows alternative prices and the quantities
that people are willing and able to purchase at these prices. This is called a demand
schedule. It is clear that if tutoring prices are low (say, $2 per hour), the quantity
demanded will be high (80 hours). If tutoring prices are higher ($4 per hour), the
quantity demanded will be lower (40 hours). This simple common sense idea that people
will be willing and able to buy more of a good or service at low prices than at high prices is
a fundamental economic principle, the law of demand, which is usually stated as
follows: price and quantity demanded are negatively related, all other things equal. This
means that when price goes up, quantity demanded goes down, and vice versa.
                                    
We can place the information from Table 1.2 into a graph of demand, illustrated
in Figure 1.3. A graph of demand is referred to as a demand curve (even though
demand curves are often drawn as straight lines). The price of tutoring services (P) is
on the vertical axis, and the quantity of services demanded (number of hours) is on the
horizontal axis, which is labelled Q for quantity. Plotting the information in each of the
rows a through e in the table gives us points a through e in the graph. Connecting these
points gives us the demand curve in Figure 1.3. The demand curve (labelled D for
demand) indicates all possible combinations of alternative prices and quantity
demanded, assuming that all factors except price that could affect quantity demanded
are held constant.
                                       
Note that the demand curve is downward sloping, reflecting the law of demand. A
higher price is associated with a lower quantity demanded (40 hours at $4 per hour),
whereas a lower price is associated with a larger quantity demanded (80 hours at $2
per hour).
What if one of the other factors affecting demand was to change? Course
difficulty might increase, for example. Or student incomes might increase, making
students better able to afford tutoring. Each of these examples would increase the
demand for tutoring services. You probably can add to the list of things that would
increase the demand for tutoring.
An increase in the demand for tutoring services will result in an entirely new
demand schedule, such as the one in Table 1.3. We can plot this new information in the
same graph as before, and we end up with an entirely new demand curve, D’. (See
Figure 1.3.) Demand has increased so the demand curve has shifted forward, or to the
right. Note that for every price that existed before, a higher quantity demanded now
exists.
                    
 
Supply
Now let’s consider the other side of the market for tutoring services, the supply
side. Imagine the students at your school who not only don’t need tutoring but who are
actually able to tutor. This is the group of students who might supply tutoring services
for a fee. What are the factors that influence these students’ willingness to offer their
tutoring services for sale? Probably the costs associated with providing the service are
important. The most obvious cost is the value of the tutor’s time. Remember that
opportunity costs are always important. The opportunity costs Of a tutor’s time may be
quantified easily if an adult tutor hires a babysitter while he or she tutors or if the tutor
forgoes income from alternative employment. Some costs that are less easy to quantify
are just as real. The tutor might be giving up precious study time, quality time with
friends and family, or simply valued leisure time. Although it’s hard to attach a dollar
value to these costs, they remain important. Remember that there is no free lunch;
every choice has an opportunity cost; every activity chosen entails another activity
given up.
Another factor affecting the total quantity of tutoring services supplied will be the
number of ~ tutors available. If we experience an increase in enrolment of top-notch
students who are dying to become tutors, we can expect more tutoring services
suddenly to be supplied.
The price that tutors can receive for their services will also be an important
determinant of their willingness to supply these services. Let’s focus our attention on
this price variable for a moment. Let’s look at the supply of tutoring services in a one-
week time period, when all the factors except price that might affect the number of
tutoring hours supplied are held constant. It is realistic to assume that individual tutors
will be more willing to provide tutoring services at a high price than at a low price. The
higher price will allow them to cover their babysitting expenses more easily or will serve
as a stronger inducement to give up leisure or time with friends and family. It will
compensate them better for other job prospects they don’t pursue because they are
tutoring. In simple terms, the higher the price, the greater the incentive to provide
tutoring services. Tutors (and business firms) will offer for sale a larger amount of the
good or service at higher prices rather than at lower prices. This is known as the law of
supply, which is usually stated as follows: price and quantity supplied are positively
related, all other things equal. This simply means that price and quantity supplied (the
amount offered for sale) change in the same direction. If price goes up, so does quantity
supplied; if price goes down, so does quantity supplied.
The behavior of all tutors as a group might be summarized in Table 1.4, which is
a supply schedule showing different quantities of tutoring hours supplied (Q3) at the
alternative prices (P) that the tutors might receive. The quantities represent the total
number of hours supplied by the group as a whole at each alternative price over the
specified one week time period All the factors other than price that might affect the
tutors’ willingness to tutor do not change. Thus, the only thing changing is the price
determinant.
We can place the information from the supply schedule in Table 1.4 into a graph
of supply, or a supply curve in Figure 1.5. The axes are identical to those in the demand
graphs, with price on the vertical axis and quantity on the horizontal axis. Plotting the
information in each of the rows V through Z gives us points V through Z on the graph.
Connecting these points gives us the supply curve 5 in Figure 1.5.
Table 1.4
                                                      
 
Figure 1.5. Supply Curve for Tutoring Services, One Week
The graph  shows amounts of tutoring supplied at various prices.

 
The supply curve indicates all possible combinations of quantity supplied
and alternative prices with the assumption that all other factors affecting supply
are held constant. Note that the supply curve is upward sloping, reflecting the law
of supply: price and quantity supplied increase together.
What if one of the other factors affecting supply was to change?
Babysitting costs might decrease so that some tutors would be more willing to
provide tutoring services, for example. This would increase the supply of tutoring
services. You can probably list other factors that would increase the supply of
tutoring. Changes in the costs of producing or supplying a product are among the
most important factors causing a shift in the supply curve.
 An increase in the supply of tutoring services as a result of lower
babysitting costs will result in an entirely new supply schedule, such as the one
shown in Table 1.5. Note that for each price, a larger quantity supplied now
exists.
                                        
If we plot this new information on the same graph as the original supply
curve, we have an. entirely new supply curve 8’, as indicated in Figure 1.6.
Supply has increased, and the supply curve has shifted forward, or to the right,
showing increased quantities supplied at each of the given prices. Lower costs
always cause a forward shift in the curve, whereas higher costs always cause a
backward shift in the curve.
Figure 1.6
                                                
Putting Demand and Supply Together
We can now consider the entire market for tutoring services at your school
for the time period of one week. We have a demand schedule (or curve) that
reflects the buyers’ (students’) attitudes toward purchasing tutoring services. And
we have a supply schedule (or curve) that reflects the sellers’ (tutors’) attitudes
toward supplying tutoring services. We simply have to put demand and supply
together. Let’s put them together graphically first. We will consider the original
demand curve D and the original supply curve S, which are shown together in
Figure 1.7.
Figure 1.7 Market for Tutoring Services, One Week
The market will clear at point E. At $3, quantity demanded equals quantity supplied

As you can see, there is only one point in the graph (point B) where
quantity demanded (which we read off the demand curve D) is equal to quantity
supplied (which we read off the supply curve S). This point occurs at the
intersection of demand and supply and corresponds to a price of $3 and
quantities demanded and supplied of 60 hours a week. At point B, the market for
tutoring services is in equilibrium, or a state of balance, because the amount of
tutoring services that students are willing and able to purchase is identical to the
amount that tutors are willing to provide. This equilibrium can also be seen in
Table 1.6, which shows the original supply and demand schedules and (in bold)
the equilibrium price and quantity.
The market for tutoring services naturally tends to move toward the equilibrium
point. To illustrate this tendency, consider what would happen if tutors were charging
less than the equilibrium price of $3 an hour. Suppose that the tutors were charging only
$1 an hour. At $1, the quantity demanded (100) exceeds the quantity supplied (20) by
80 hours. There would be a shortage of tutoring services of 80 hours, because at $1,
buyers regard tutoring as a bargain, whereas sellers have little incentive to provide
tutoring. (Note that in a technical sense, shortages only occur when market prices are
below the equilibrium price.) Students will bid for the tutoring services that are available,
and in the process the price will be bid up. Put yourself in the position of a student who
needs tutoring. You would quite likely offer slightly more than $1 to a tutor so that you
would receive the tutoring instead of your friend. Your (former) friend would probably be
trying to do the same. In this process, the average price of tutoring would be pushed up.
The bidding up of the price will continue only as long as the shortage exists, and as the
price rises, the shortage will disappear. Two things happen as price increases: (1)
buyers decrease the quantity they demand, and (2) sellers increase the quantity they
offer for sale. This process of rising price, decreasing quantity demanded, and
increasing quantity supplied is shown in Figure 1.8. The process will come to a
screeching halt when equilibrium is reached at point B. Because the shortage no longer
exists, the price will rise no higher. Economists usually refer to this phenomenon as the
rationing function of price. This means that the movement of the price has ultimately
rationed away the shortage. Without the ability of prices to adjust by moving upward, the
shortage would have persisted indefinitely. Socialist countries have often done just that-
they have prohibited prices from adjusting upward. As a result, shortages have been
commonplace.
Now consider the opposite possibility. Tutors might be charging a price-say, $5
-that is above the equilibrium price. Perhaps they feel that they can make a lot' of
income at this high price. There is, however, a problem in the market at this price. At $5
an hour, the quantity (20 hours per week) of tutoring services demanded will be very
small. But tutors will be willing to supply a large quantity (100 hours per week) because
they have so much incentive. The difference between the quantity that tutors supply and
the amount that students actually buy (quantity demanded) is a surplus of unsold
services in the market. (Note again that in a technical sense, surpluses only occur when
market prices are above the equilibrium price.) Surpluses cause the price to fall. Tutors
will undercut one another’s price to get some business, and the price will fall until it
reaches the $3 equilibrium. As the price decreases, quantity demanded will increase,
quantity supplied will decrease, and the surplus will disappear. This process is
illustrated in Figure 1.9. The process comes to a halt when equilibrium is reached. The
falling price has rationed away the surplus.
Figure 1.9 Response to a Surplus of Tutoring Services

Shifts in Demand and Supply

The market for tutoring services will remain in equilibrium at point B unless some
other factor affecting the market changes. Because things rarely remain unchanged, it is
important to consider what might happen if the variables affecting either the demand for
or the supply of tutoring services were to change.
Consider our earlier example in which an increase in student incomes caused an
increase in the demand for tutoring services. The only thing that we are doing differently
now is considering this shift in demand in the context of demand, supply, and
equilibrium. The demand curve will shift forward to D ’, as illustrated in Figure 1.10.
 Figure 1.10 Effects of Increased Demand for Tutoring Services

Note that the supply curve will not shift. The old demand curve D’ becomes
irrelevant, and a new equilibrium E exists at the intersection of the new demand curve D
and the old supply curve 8. By reading the new equilibrium price and quantity off the
respective axes, we see that price has increased to $4 an hour and quantity has
increased to 80 hours per week. Because demand has increased, the market price has
increased, and suppliers have moved up their supply curve and increased the amount
that they are willing to offer for sale (the quantity supplied). The increased demand
curve and the unchanged supply curve have thus caused an increase in both
equilibrium price and equilibrium quantity.
The opposite phenomenon would have occurred if there had been a decrease in
demand. If student incomes had decreased, causing a decrease in demand, the
demand curve would have shifted backward. The new equilibrium point would show that
both price and quantity would have decreased.
Now consider the supply side of the tutoring market. Recall that a decrease in
babysitting costs causes an increase in the supply of tutoring. If this increase occurs,
the supply curve will shift forward but the demand curve will not shift. This phenomenon
is illustrated by the shift of supply from S to S’ in Figure 1.11.
Figure 1.11 Effects of Increased Supply of Tutoring Services

The new equilibrium E' is found at the intersection of the original demand curve D
and the new supply curve 8'. We see that the price has decreased to $2 an hour, while
the quantity has increased to 80 hours per week. As a result of an increase in supply,
the market price went down, so students (consumers) moved down along their demand
curve, increasing the amount of tutoring services that they were willing and able to buy.
Because supply increased, price decreased and the quantity exchanged increased. The
increased supply curve and the unchanged demand curve have caused a decrease in
the equilibrium price and an increase in the equilibrium quantity.
If supply had decreased because babysitting costs had increased, causing tutors
to desire a higher price for tutoring services, the opposite phenomenon would have
occurred. The supply curve would have shifted backward, resulting in a new equilibrium.
The market price would be higher, but the equilibrium quantity would be lower.
 
The Real World
Whew! What a lot of graphs! But you now have learned the basic tools to answer
many of life’s economic questions. All markets have a demand (buyer’s) side and a
supply (seller’s) side. And the things that affect supply and demand are the common
sense sorts of things described in the tutoring market example.
 Demand curves shift if the number of buyers changes, if consumers’ tastes
change, or if the prices of other goods that the consumers regard as substitutes or
complements change. In our tutoring example, a substitute .for tutoring might be buying
and using a study guide that goes along with a textbook. Substitute relationships occur
when the consumer substitutes one good for the other good. A classic example of
substitutes is butter and margarine. Complements are the opposite of substitutes. If the
consumer uses more of one good, he or she will also use more of the other. A good
example of complementary goods is digital cameras and memory cards. If the price of
digital cameras goes down, all other things constant, more digital cameras will be
purchased. With more digital cameras in the hands of consumers, there will be a greater
demand for memory cards. Another example of a situation causing a shift in demand
would be an increase in consumer incomes. While we normally expect an increase in
income to cause an increase in demand, this is not always the case. Consider flat
screen televisions, for example. A rise in consumer income will most likely cause a
decrease in demand for flat screen televisions (whose price is now fairly low), but an
increase in the demand for three-dimensional TV sets (still quite expensive).
A final example of a circumstance causing a shift in demand might be an
expectation of the future. So if you read in the newspapers that a large increase in the
price of toilet paper is expected next month, you and others may run out to buy toilet
paper today, with the increased current demand actually causing a rise in its price (a
self-fulfilling prophesy that is not uncommon in economics).
Supply curves shift if the number of sellers changes or if the factors that affect
the producers’ (sellers’) costs change. So, a rise in the energy costs of a manufacturer
will decrease the supply of manufactured goods. If businesses must pay higher wage
rates to produce the same amount of output; the supply of output will decrease. On the
other hand, if the price of raw materials goes down, the supply of the product for which
the materials are used will increase. If technology improves, such that it becomes
cheaper and easier to produce a product, supply of the product will increase. If the
government taxes the production of a good or service or imposes costly regulations on
the supplier, the supply of output will decrease; if the government provides subsidies
(which lowers costs), however, the supply of the product will increase. Because these
examples involve costs of production, we can think of higher costs of production as
squeezing a supplier’s profit margin, and thereby reducing incentives to supply the
product. This would ultimately increase the price of the final product. Lower costs of
production would do the opposite.
 
Figure 1.12 Summary of the factors that commonly cause the real-world demand and supply curves to shift.

Efficiency and Equity

In many ways, prices encourage thrift and careful choices among competing
goods. Goods and services are allocated to those most willing to pay. Thus, the market
is an effective allocative device. Without prices, products might go to people who do not
strongly desire them and thus be wasted. Shortages of highly desirable goods and
surpluses of less desirable ones might occur. But in the market, prices ration away
these shortages and surpluses, suggesting that the marketplace is very efficient as a
means of allocation and distribution.
On the other hand, the distribution of goods and services may not be
equitable. Equity is a value-laden concept, and economists cannot say whether a
particular distribution is fair. But certain results of market activity may not seem fair to
some of us. A student may truly need tutoring services but not be able to afford them
and thus fail the course. Children may go without milk, the homeless without shelter,
and poor pregnant women without prenatal care because their low incomes render them
unable to pay the prices that the market determines for these products. We might
summarize by saying that the market entails both positive and negative aspects. The
market place is often efficient, but not necessarily equitable.
 
Market Failures and a Glimpse of the Future
Most economists agree that the marketplace performs many useful functions. In
addition to efficiency, a market-based economy provides economic incentives and tends
to be highly productive. The combination of competition and proper price signals
encourages efficient production of the products desired by consumers in the least costly
manner. .
Despite the benefits of a market economy, most economists recognize that the
marketplace can also fail. The existence of many market failures does not necessarily
imply that the marketplace itself ' is a failure. Rather, it points to ways that the
government may become involved in the marketplace to assure that all societal needs
are met.
Market failures include the following:
Public Goods and Services
Public goods and services have unique characteristics that make it unlikely that
the market will provide enough of them. As a result, the government often provides
them. Public goods and services include national defense, public libraries, highway
construction, crime prevention, public education, and others. At least to some point, the
use of public goods and services by some of us does not keep others from using them.
You’re driving on a country road does not keep others from driving along it. Public
goods and services are unlikely to be provided by the marketplace because they cannot
be divided into small segments and offered for sale.
Example: It doesn’t make sense for each individual consumer to purchase one
mile of the country road. Furthermore, if a private consumer does buy such a
good or service, it is difficult to keep people who do not pay for the product from
using it. Am I going to stand all day to make sure you do not drive on my own
personal mile of the road? The entire notion of a private market for this country
road takes on ridiculous proportions. It makes far more sense for the local
government to provide the road and ensure its repair. Most economists agree
 that the provision of public goods and services is an appropriate role for
government. Our disagreement concerns just what goods and services these will
be, and how much of them we want.
Spillovers
Neither economic efficiency nor equity occurs when spillovers exist. Economic
spillovers occur when some cost (or benefit) related to production or consumption “spills
over” onto people not involved in the production or consumption of the good.
Pollution of our environment is the most obvious example. If a manufacturer
pollutes our air and water in the process of production, we will bear the costs of this
pollution even if we don’t own the company, acquire its profits, or buy its products. We
bear the costs of pollution in terms of greater risk of illness, less aesthetic beauty, and
lower-quality environment. The manufacturer has based its decisions on the profit
motive, and has shifted part of the costs of production to society at large. Our natural
resources are not being used appropriately, and our economy is not addressing our real
needs and concerns. Our own dissatisfaction with the degraded environment will not
remedy the problem unless collectively we are able to channel our concern through
active government involvement.
Other goods and services provide spillover benefits to
society. Education provides significant spillover benefits to society. The educated person
is likely to provide innovation and creativity in the production process, and is more likely
to vote and otherwise participate in government and public affairs. The educated person
is less likely to be chronically unemployed or to commit a violent crime. He or she is
more likely to pay taxes and less likely to be on welfare. The market will not, by itself,
provide sufficient levels of education, nor does it adequately compensate students for
acquiring (and paying for) education, because the market place alone does not reflect
these spillover benefits.
lnequity
We’ve already noted that the marketplace is not necessarily equitable. Aside
from discrimination, poverty and inequality of income distribution are also issues of
equity. We may argue that the inability of low-income people to meet their basic needs
is unfair. Housing, health care, and social security also raise issues of equity.
Market Power
Our example of the demand and supply of tutoring services at a large university
is one that approximates pure competition. There were many suppliers of tutoring
services so that no single tutor could dictate the market price. If one of 100 tutors were
to charge an exorbitant price, students would seek the services of the other 99.
Competition protects us from unreasonable prices. We would not be protected if there
were only one tutor. This monopoly supplier of tutoring services could charge a high
price and consumers desiring the service would be forced to pay it. Even if there were a
few more tutors available, this small group could hold back-alley meetings and fix the
price of their services at a very high level.
 Without competition, we would be at the mercy of this group. We would say that
the single supplier and/or the price-fixing group possess market power, which is the
ability of a supplier to influence the market price of its product. It is only with a large
number of tutors-so many that it is unrealistic for them all to come to agreement about
prices and so many that no individual supplier produces for a large share of the market-
that market power is absent. To the extent that many industries consist of just a few
dominant producers (examples are the automobile, steel, and breakfast cereal
industries), competition is reduced and society’s well-being suffers. Examples of firms
charged with abusing their market power include Microsoft and Apple. Because market
power arises when a small number of suppliers influence the market price of their
product, it is reasonable to conclude that a larger number of suppliers, whether these
are domestic or foreign producers, will serve to reduce market power. Many people are
unaware of the important contribution of international trade in enhancing competition
and reducing market power.
Instability
Finally, we return to the topic of production possibilities and employment. The
factors that determine whether our nation will be on the production possibilities curve
(operating at full employment) or below the production possibilities curve (with
unemployed resources) are very volatile. Thus, at times we may have very low
employment, and at other times we may have high employment. Closely related are the
factors affecting the average level of prices throughout our economy. When the average
price level rises, we say that we have inflation. Because prices and employment tend to
fluctuate, many say that our market economy is inherently unstable. In the process, we
discover how our government and our central banking system can intervene in many
ways to ensure greater stability of prices and employment.
 
Overview Of Economic Development
Introduction
The enormous interest in the economic development of postwar East Asia has
continued into the new millennium. The region’s recent economic history has been
marked by an “economic miracle” that spanned several decades followed by a severe
financial and economic crisis. Problems of widespread poverty and economic inequality
remain despite significant economic progress. Addressing these issues, as well as the
impact of developments in the world economy, is a challenge the region’s governments,
international organizations, and the economics profession face as a whole. The region
provides fertile ground for economists to study and address a wide variety of economic
development issues.
East Asia stands out because of the dynamic economic growth and development
it has achieved throughout the postwar period. The development process began in
Japan when it opened its economy to increased trade and investment. The rapid
industrialization that followed quickly spread to the neighboring economies of South
Korea, Singapore, Taiwan, and Hong Kong. Economic growth in these Newly
Industrialized Economies (NIEs), sometimes called the Asian “tigers,” averaged 8
percent a year in the three decades prior to the Asian financial crisis in 1997. This
growth continued despite two oil crises in the 1970s, a sluggish world economy in the
early 1980s, and rising protectionism and currency appreciation in the latter half of the
eighties.
The industrialization experiences of Japan and these Asian ‘tigers” formed the
basis of the “East Asian development model,” which has now become an accepted part
of economic development literature. Recent studies have used this model to
characterize the growth and development in the neighboring ASEAN economies and
China. Inspired by the success of Japan and the NIEs, Indonesia, Malaysia, Thailand,
and the Philippines developed strategies that promoted the inflow of foreign capital and
encouraged exports. These outward-oriented economic policies fuelled rapid growth
during the 1980s. China’s economic growth and development has likewise accelerated
since the late 1970s when its government shifted to an open-door policy that promoted
foreign investment and exports.
However, the remarkable economic record of the Asian economies was marred
by the Asian financial crisis. Triggered by the collapse of the Thai baht in July 1997,
equity markets and currencies throughout Southeast Asia came under great pressure
and the ensuing currency devaluations led to foreign capital flight. Consequently, in a
matter of two months or so, Asia’s once vibrant economies were plunged into deep
recession. This economic collapse forced an unprecedented reappraisal of policies
ranging from corporate government to exchange rate management. It also forced a
rethink of the prescriptive policies imposed on the ailing economies by international
development institutions such as the International Monetary Fund (IMF) and the World
Bank.
After the sharp economic contraction in 1998, the region rebounded rapidly. In
South Korea, for example, year-on-year industrial production and gross domestic
product (GDP) increased dramatically in 1999 while stock market values doubled in
Thailand and Malaysia. The primary equity market indexes in Seoul and Singapore
returned to their pre-crisis levels. However, as the US. economy slowed in 2001 and
2002, and war in Iraq and the spread of the SARS virus took place in 2003, prospects
for the region were adversely affected and the future became uncertain. And currently,
the strike of the COVID-19 pandemic.
The financial crisis also hampered progress in reducing poverty and addressing
other social issues. The human development gains in health, education, poverty, and
equality, and the distribution of income achieved by East Asia in the two decades prior
to the crises was eroded to some degree, resulting in slower growth.
There is no doubt, however, that the economies of East Asia are in the process
of recovering from the crisis and the region, as a whole, will play a major role in the
global, high-tech world economy that we are moving towards in this new millennium.
In South Asia, where the impact of the financial crisis on the region was not as
severe, economic progress has accelerated following a shift in policy in the late 1980s
and early 1990s. Nevertheless, this region faces a number of challenges, including
further progress in reducing poverty and the resolution of political disputes that have
drawn resources away from economic development. 
 How is Development Economics Distinct from other Aspects of Economics?
In today’s classrooms, economic development concentrates on economies that have
low per-capita incomes. These economies are set apart, for argument’s sake, from the
industrial economies of Europe, North America, Japan, and Australia/New Zealand.
Economic development considers the experience of these industrial countries as
relevant for analyzing the process of economic growth. In Asia, there are many poor
countries, as well as some that have recently joined the group of industrialized
countries, such as Singapore, Hong Kong, Korea, and Taiwan. We will study all of
these Asian economies, particularly those that have been highly successful in achieving
high growth and high levels of per-capita income. Many useful lessons can be learned
from them by comparing their development experience with economies that have grown
less rapidly. But we will not deal with the economies of Central Asia, rather, we focus on
East and Southeast Asia, and South Asia. Development economists also make use of
analytical tools and methods developed in a variety of other branches of economics,
such as growth theory, macroeconomics, microeconomics, and labor, to name just a
few. They apply these tools of analysis to the problems and challenges of developing
countries.   
Measuring Growth and Development
For many years, economic development was considered to be synonymous with
economic growth either total economic growth or economic growth in per-capita terms.
The two concepts of economic growth and economic development are, however, not
necessarily the same. The concept of economic development is a broader and much
more encompassing view than economic growth, and relates to levels of social and
humanitarian achievement and income distribution, as well as a narrower measure of
per-capita income.
Using a measure of the amount of goods and services produced in an economy
in a year, we can get some idea about the standard of living in that economy. When the
value of these goods increases over time, there is economic growth. Gross domestic
product (the total value of production in an economy) or gross national product (GNP-
which is GDP plus net factor income from abroad) is used as a measure of the nation’s
income or production. The size of the total population can be used to deflate it to per-
capita terms. An improvement in the living standards of the population is a natural
consequence of economic growth over a period of time. Thus, by looking at GDP or
GNP growth rates, we get some idea about living standards and how they change over
time. Comparisons of these figures also allow us to relate the performances of countries
or regions in terms of their growth.
Table 2.1 shows a clearer picture of economic growth over time as it takes into
account population changes by using data for GDP per capita for 1960 and 2007 Since
GDP per capita measures the level of GDP for each country, it is an indication of the
standard of living at the individual country level. As can be seen, GDP per capita in the
MRS, such as Singapore, Hong Kong, and Korea, grew rapidly while other countries
such as India and Nepal grew at a slower rate. Current figures show that Singapore’s
GDP per capita is almost twice that of Korea; more than six times that of Malaysia, and
more than sixteen times that of China
As noted above, when we speak of economic development, we usually mean
economic growth accompanied by an improvement in the peoples’ quality of life. To a
large degree, economic development results from economic growth. However, the
experiences of many economies have shown that economic growth can occur without
any improvement in the quality of the lives of its people. A case in point is the resource-
rich country of Papua New Guinea. Its mineral-based modern economic sector has
grown quite rapidly in the past few decades, pushing up total income and income per
capita. In spite of this, it is common to find households in the rural areas continuing to
live at a subsistence level. The fruits of this economic growth have not been distributed
throughout the society and the government still provides few opportunities for education
and health. Human development indicators, such as life expectancy, infant mortality,
and the average level of educational attainment have lagged behind those of the other
countries in the Asian region.
As a result, there is a growing awareness that the concepts of GDP (and GNP)
need to be broadened in order to include other factors that measure economic
development. As they stand, GDP and GNP are not sufficiently balanced to adequately
capture the essence of economic development.
New Approaches to Measuring Economic Development

1. The Human Development Index (HDI)

The United Nations Development Program (UNDP) developed the HDI in the late
1980s and has been publishing it since 1990. This index has three components: per-
capita income and two additional measures - life expectancy at birth, and level of
educational attainment that combines adult literacy and educational enrolment
rates. These are added to per-capita income, which is adjusted to reflect the diminishing
marginal use of money, to obtain HDI. The HDI is developed as a ratio of a particular
country to the most developed country. It varies between zero and one. Both of these
additional indicators are somewhat related to per-capita income. However, the HDI can
be useful in recognizing that some countries may have rather low income levels, but still
have achieved a lot in terms of satisfying human needs (see Table 2.2, ranked in terms
of descending HDI values). Examples are Sri Lanka, China, and several countries in
Central Asia. For other countries, such as Papua New Guinea and Pakistan, the HDI is
much lower than we would expect by looking at per-capita income alone.
Several countries, such as Kuwait and Guatemala, rate much higher in per-capita
income terms than they do with respect to human development. Within Asia, the
rankings are more closely correlated.

1. Healthy Life Expectancy

A measure used by the World Health Organization (WHO) summarizes the
expected number of years to be lived in “full health.” The years of ill-health are
weighted according to severity and subtracted from the overall life expectancy rate to
give the equivalent years of healthy life. According to the latest data available from the
WHO’S Statistical Information System Online Database, Japanese men have the
longest healthy life expectancy of 72 years among 191 countries, compared with 27
years for the lowest ranking country, Sierra Leone.

1. Green GNP
One of the more recent approaches deveIoped to address the inherent
shortcomings of GDP and GNP as growth and development measures is based on what
is known as the “green” system of national accounting. Green GNP is the informal name
given to national income measures that are adjusted to take into account the depletion
of natural resources (both renewable and non-renewable) and environmental
degradation. The types of adjustments made to standard GNP would include the cost of
exploiting a natural resource and valuing the social cost of pollution emissions.
Damages to the global environment, such as global warming and depletion of the ozone
layer, should also be deducted; but these damages are hard to estimate. Others
suggest that “defensive” expenditures, those for environmental protection and
compensation for environmental damage, including medical expenses, should also be
deducted. The argument here is that these costs would not have been incurred if the
environment had not been damaged.
 
Making Comparisons Between Countries
There are two different methods currently in use for comparing income between
countries using the measure-the exchange rate method and the purchasing power
parity (PPP) method. (Note: in Table 2.2, PPP measure was used to compare GDP per
capita).
Exchange Rate Method
The exchange rate method uses the exchange rate between the local
currency and the US. dollar to convert the currency into its US. dollar equivalent.
A country’s GDP and GDP per capita would then be valued accordingly, in US dollars.
Purchasing power Parity (PPP) Method
The purchasing power parity method develops a cost index for comparable
baskets of consumption goods in the local currency and then compares this with
prices in the United State for the same set of commodities. A country’s PPP is
defined as the number of units of the country’s currency required to buy the same amount
of goods and services that a dollar would buy in the United States. Because the PPP
method uses a basket of many goods and calculates the relative price of these goods,
many economists view this as a better measure of the relative standards of living than
the conventional exchange rate method described above.
These two different methods can give widely varying estimates of GDP. In
general, the PPP method gives higher estimates of living standards for developing
countries compared with the exchange rate method. The reason is that calculations of
GDP based on exchange rate values depend only on the relative prices of traded
goods, whereas the PPP method considers a basket of goods that include both traded and
non traded goods. Nontraded goods are generally much cheaper in developing countries
and this helps to lift the estimate of GDP for these economies. A further advantage of
the PPP method is that it is unaffected by exchange rate changes. As a result of these
advantages, the PPP method has become the preferred measure of GDP for country
comparisons. One difficulty with the PPP method, however, is that it is costly to maintain
since price movements need to be updated on a regular basis.
 
Now class, here are some important comments from the topics:
Economic development is a special field of economics which concentrates on the
study of countries which are in the process of moving upward from low levels of income,
and social progress. There are many features of an economy that are relevant for
measuring its level of national well-being, including the annual production of goods and
services (GDP/GNP/GNI) and social indicators, such as life expectancy, educational
attainment, and environmental quality.
To compare and contrast the level of economic development in different
economies, it is useful to consider all these factors. In particular, it is important to
recognize that there are two popular ways to compare levels of income: the exchange
rate and purchasing power parity methods. The exchange rate method has the
advantage of simplicity and ease of calculation. The PPP method, while more costly to
calculate and maintain over time, is a better measure of relative living standards since it
is unaffected by exchange rate fluctuations and includes all goods produced rather than
traded goods only.
 
Economic Development
As noted earlier, when we speak of economic development, we usually mean
economic growth accompanied by an improvement in the peoples’ quality of life. To a
large degree, economic development results from economic growth. However, the
experiences of many economies have shown that economic growth can occur without
any improvement in the quality of the lives of its people.
An extensive amount of research work has focused on these mega-trends
impacting the global economy. 
Economic Downturn: The downturn in the U.S. and global economy has shifted
how we measure wealth (e.g., a home may no longer be a stable investment in some
areas), changed how people view savings (we see an increase in the personal savings
rate in the country), and slowed job creation dramatically.  The challenges that some
European Union counties are experiencing, the fledgling movement toward democracy
in countries like Egypt, high oil and gas prices, and the emergence of China, etc. are all
challenging our traditional approaches to economic development. 
 Loss of manufacturing jobs and growth in service industry: For example, if
you examine industry in many parts of the world, you’ll discover the lifeblood of their
economies has historically been manufacturing and agriculture.  Increasingly, the
growth industry in many countries is now service-related industries.
Polarization of work reflecting knowledge, skills and
abilities:  Employment and jobs are being polarized where wages tend to reflect the
unique knowledge, skills and abilities of workers.  Unskilled production and assembly
jobs are becoming more and more scarce. 
Outsourcing that divides ‘value-chain’: Many of the business activities
traditionally done in-house are now being outsourced.  Auto ‘manufacturers’ today are
really ‘assemblers’ as they manufacture very few of the components of a car.  Instead,
most are purchased from other vendors.  Even in the non-manufacturing sector
outsourcing can be seen through payroll, human resources, marketing, graphic design,
programming, etc.  
Importance of creative/knowledge economies:  If you’ve read any of the
works of Richard Florida over the past few years, then you know he has offered a very
compelling argument that the future health of local economies is linked to a community’s
ability to attract creative and knowledge-based workers, or to generate jobs that seek
these types of talented individuals.
Specialization of regions and communities: Regions and communities are
becoming more specialized and connected to other non-contiguous places.  Places are
more frequently connecting to other places with complementary specializations.  Focus
is on the industry/businesses that can use the region or community’s skilled workforce,
resources and assets.    
Expanded growth of entrepreneurs and the self-employed:  Across the
world, a growing number of people are starting their own businesses, many as self-
employed people.  For example, over the past two decades, the number of self-
employed people in rural America has grown by 2 million and now represents over 20
percent of its workforce.  Estimates suggest this rate will continue to accelerate over the
next decade or more.
Now, let’s look at some of the mega-trends that deal specifically with economic
development.  You may note that not all of these trends are necessarily ‘good things’
happening in the economic development arena.  Instead, some actually discuss some
of the traditional ways we have approached economic development – approaches that
may not work very well in today’s global environment.
 Where do you see disconnects between these mega-trends in economic
development and the global economy mega-trends?  Where do you think they
complement one another?
Here are some comments you might want to make on some of these
items:
 Continued focus on companies rather than industries and people:  Every
morning when economic development leaders wake up and get on with their work,
many are still focusing on attracting a major company to their community.  It doesn’t
matter to them what type of company they capture, they just want to get the number of
jobs they have attracted to go up.  Might it be a better strategy to recruit specific firms
that can further strengthen and add value to one of the region’s key industrial sectors,
especially if it’s a sector that is likely to enjoy stability or growth over the long-term?
Need for talented workforce to be competitive:  Manufacturing in the rural
U.S. represents a great example of this point.  Years ago, manufacturing plants that
were located in rural areas were looking for cheap, low-skilled labor.  In order to survive
in today’s global environment, manufacturing plants have had to raise the skill
requirements of their workers and have had to introduce technological innovations. 
Greater scrutiny of public economic development investments:  The debate
about the benefits and costs of offering incentives to companies to locate to a state or
community remains pretty heated.  Do publicly paid incentives for such purposes work? 
The research seems to be mixed, and with the increasing scrutiny by citizens on how
taxpayer monies are used, this is a debate that is likely to rage on for some time.
“The evolution of economic development is often discussed in terms of the ‘three
waves.’
The FIRST WAVE was dominated by programs specifically designed to attract
footloose firms from old industrial areas to growing regions, such as the South or West. 
The typical tools included subsidized loans or direct payments to firms for relocation
expenses, tax reductions, subsidies applied to the cost of plant facilities or utilities, and
competitive and expensive industrial recruitment programs.  The building of industrial
parks was also part of the first wave strategy.
By the early 1980s, states began operating many SECOND WAVE incentives,
ones that shifted focus from attracting out-of-state firms to retaining and expanding
existing firms.  With the introduction of deregulation in the early 1980s, firms had to find
ways to reduce costs in order to compete.  In some cases, manufacturing firms
embraced lean manufacturing strategies in hopes of reducing inefficiencies in their
production activities.  Other companies consolidated in order to reduce costs.  It was
during this period that job training and technical assistance activities targeted to
businesses were on the rise, including support for business start-ups.  The bottom line
was to strengthen the health of existing industries. 
The second wave has now given way to the THIRD WAVE which shifts the
focus to regional competitiveness, focusing on efforts to promote innovation and
entrepreneurial activities.  In some cases, attention is given to the strategic linking of
similar types of businesses in order to create clusters.  In other situations, the focus is
on unique regional assets or amenities (such as the growth of the artisans region in
North Carolina under the banner of Handmade in America).  A third aspect of this wave
is focused on seeding the growth of entrepreneurs as a way of introducing new products
or services, especially products and services that relate to and help strengthen the
regional aspects of the economy. 
 Many regions are now pursuing some combination of these regional strategies. 
In some cases, this includes the building of the right regional governance structure to
help get these types of efforts off the ground.  Leadership development activities have
been a fruitful way to help create and strengthen the emergence of effective regional
governance structures.”
Another way to consider the changes in economic development is to look at the
shift that is occurring, that is, from OLD to NEW. In the past, the primary approach was a
focus on attraction (e.g., the effort to incent a company to move from an existing
location to another location) with little focus on supporting and retaining existing
businesses.
Too often the message was that our location is a ‘cheap’ place to do business
(e.g., we have cheap land, cheap labor [people who work for low wages], and low or
non-existent taxes).  A great physical environment (parks, bike paths, vibrant downtown,
social activities, etc.) was considered a luxury, as we had to use available financial
resources to attract the companies, not create a great community. 
Most communities and regions worked hard to develop a competitive advantage
in a resource (wood, a particular industry, lots of water, workers with specific skill).  
They tended to ‘win’ because of this advantage.  One example is regions that had a
concentration in the auto industry.  Because of that concentration, they tended to attract
more linked businesses. 
Economic development was also always led by a state or local government
agency with little input or involvement from the business community or the nonprofit
sector.
Economic development now focuses much more on creativity, entrepreneurial spirit and
range of worker talent.  Available land, low taxes and incentives are still factors, but not
the primary factors as in the past.  There is a strong focus on the region, rather than a
single community.  To be successful, these regions must have the ability to learn and
adapt to the changing global economy.
Most importantly, economic development today is successful only when a
partnership between the business, government and nonprofit sectors exists.  By working
together, they can create a community/region that is attractive to new residents
(workers) and businesses, while continuing to provide for the existing businesses and
residents. 
 
Economic Growth
This is the rise in the money value of goods and services produced by all the
sectors of the economy per head during a particular period. Moreover, it can be
expressed in terms of GDP and GNP that helps in measuring the size of the economy.
Economic Growth Determinants include the following:
 Human resources
  Natural resources
 Capital formation
 Technological development
 Political and Social factors
 
Why do economies grow? Why should they grow? Why do we want them to
grow faster?
These are the sorts of questions that economic development and
macroeconomic subjects are concerned with. Of course, there are many other subjects
that economists are interested in, but we will be primarily looking at economic growth
and economic development. Some economists like to distinguish between growth and
development.
 
IMPORTANT CONCEPTS FOR UNDERSTANDING GROWTH
We will study a number of theories that may explain the growth experiences of
countries over time. To facilitate understanding of these theories, we first discuss some
fundamental economic concepts.
Components of Income and Output
Output is derived by combining various factors of production, which include land,
capital and labor. Normally, we take the supply of land as fixed and assume that its
productivity can be enhanced by the application of labor or capital, the two variable
inputs which are combined in a standard production function.
The production function is a useful tool for analyzing the process of economic
growth. A production function relates the inputs of the production process, such as labor
(L) and capital (K), to the output/income (Y) from the process. This relationship can be
stated in a number of ways. A general function (f) without any functional form can be
stated as:
Y= f(K, L)
As labor and capital grow over time, so will income. What are some of the
attributes of this relationship?
To a large extent, the law of diminishing returns governs the growth process. As
each worker acquires more capital, it follows that there would be diminishing returns to
that capital. If this process were to continue for a long enough period, growth would
slow to zero. However, this has not been the experience of the industrialized nations.
Why? This is principally because of changes in the nature of the capital and labor and
the way they are organized to produce output. The former is sometimes
called embodied technical progress, and the latter disembodied technical progress.
 Embodied technical progress is reflected by the fact that labor forces have
tended to become more educated over time as more resources are spent on upgrading
the skills of the existing labor force and also on educating the young. Technological
developments also tend to increase the productivity of capital. These developments are
the result of innovation and invention. In the last decade, advances in information and
computer technology have been the most apparent sources of innovation. These have
both changed the nature of capital and labor inputs and the way that they are combined
to create output.
In terms of the kind of disembodied technical progress seen in applications in
information and computer technology, there have been advances in management and
industrial organization that have increased the level of output even when the amounts of
labor and capital are fixed. The Internet as a tool for communication, information
collection, and dissemination has increased in importance, and the use of computers to
monitor and control production has become widespread. As a result, production
processes have been streamlined, the need to keep large inventory of raw and semi-
finished goods has been reduced, and the flexibility of production processes has
increased.
To summarize, at any level of capital and labor inputs, there will be an associated
level of output. When the output increases at the same rate as the inputs, we refer to
the production function as having constant returns to scale. This means that in
Equation Y=f(K, L)  we could multiply each input by some constant and the output would
increase by that constant amount.
In what follows, we will explore various aspects of the production function and
technology that can change the relationship. For example, researchers have studied the
rate of increase in labor, capital, and output. The evidence from these studies suggests
that output increases more rapidly than inputs. If technology were fixed, this would imply
that there would be increasing returns to scale, that is, that output would increase faster
than inputs. However, as technology has changed, we have to interpret the difference
between input and output growth in a slightly different way.
The size of the labor force will increase over time as a lagged consequence of
the natural increase in population. The capital stock will also increase as a result of
investment. While it depends on how these factors are combined and the shape of the
production function, increases in labor and capital will result in an increase in output and
income. Historically, there has been a significant rate of growth per-capita income over
time and this has resulted in higher standards of living more goods and services per
capita-for many regions of the world. The Contribution of the two kinds of technological
advance has also played a critical role in raising the standards of living. The next
section will discuss how these two distinct contributing factors of embodied and
disembodied technical progress can be measured.
Total Factor Productivity
By investigating the rate of growth of labor and capital together with income and
output, economists have observed that there is some growth in output that is
unaccounted for by the growth of labor and capital in the standard production functions,
even when adjustments are made in the quality of the labor and capital inputs. In some
cases, this discrepancy or residual is quite large. This residual has been called  total
factor productivity (TFP), or multifactor productivity.
TFP pertains to the efficiency with which the inputs are combined to produce
output. These efficiency gains can be due to a number of factors, including greater
economies of scale, better management, marketing or organizational abilities, shifts in
production from low productivity activities to higher productivity activities with the same
amount of labor and capital, or the impact of new technology which enables greater
output to be obtained with the same capital and labor inputs.
If we call this TFP, or multifactor productivity, term A, and denote capital and
labor by K and L respectively, then the production function can be rewritten as Y=f(K, L,
A). This equation is a general expression. Often, economists assume that competitive
conditions exist in capital and labor markets and there are constant returns to scale. If
this is the case, then we can show that the growth rate of income is equal to the growth
rates of the capital and labor inputs weighted by their shares in national income:
g(Y) =g(K) W(K) +g(L) W(L) + A
where g(Y) is the growth rate of income, g(K) is the growth rate of capital (investment),
g(L) is the growth rate of labor, and W(K) and W(L) are the weighted shares of capital
and labor in the economy. The growth rate of income thus equals the sum of the three
terms. The first term is the growth rate of capital multiplied by the ratio of capital to
labor, and by a term that is the marginal product of capital. The second term is similar to
the first term except that it is for labor. The third term involves the efficiency factor, A.
If we assume that labor and capital are paid the value of their marginal products,
the result would be that the growth in output would be equal to the sum of three factors:
the growth rate of capital multiplied by its share of output plus the growth rate of labor
multiplied by labor’s share in output plus a residual term. Notice that this residual term
measures both embodied and disembodied technical progress. To the extent that we
can adjust the labor and capital inputs to reflect changes in the level of skill of the labor
force and the quality of capital inputs, we can incorporate embodied technical progress
into the first two terms. However, to the extent that we miss out on some of this
embodied technical progress, it will be included in the efficiency term A.
Working through an example, suppose a country has a growth rate of income of
6 percent, a growth rate of capital (net of depreciation) of 10 percent, and capital’s
share of income is 30-percent, labor’s Share is 70 percent and labor grows at 1 percent,
then the sum of the terms on the right-hand side, apart from A, will be
0.06 = A + 0.3(0.10) + 0.7(0.01)
In this example, A = 0.023 and technical progress accounts for just a little less
than 40 percent of the output growth of 6 percent. There are, of course, many
assumptions in this model. The biggest assumption is that factors are paid the value of
their marginal product and that the two factors, K and L, exhaust total output, in the
sense that their coefficients add up to one. This is essentially a constant return to scale
argument so that we do not allow for output growth to exceed the rate of growth of labor
and capital.
Notice also that the growth in income will be raised if the investment rate is
increased or if the labor force increases more rapidly. Efficiency, meanwhile, is
assumed to be unchanged.
Economic Efficiency
The production possibility frontier (PPF) is a curve depicting the best possible
combination of goods that is produced in an economy-best in the sense that the
combination utilizes all the available inputs efficiently and minimizes waste. The case for
an economy that produces only two goods-cell phones and jeans-is shown in Figure
3.1. In Figure 3.1a, the point A on the y axis is the production option where all inputs are
used to manufacture cell phones only, while the point D on the x axis is the production
option that uses all available inputs for the productions of jeans alone. The points B and
C are production options where all available inputs are used for the production of some
cell phones and jeans. Each point-A, B, C, and D (as well as other combinations on the
curve)--trace the PPF curve of the economy. Each point on this curve represents the
maximum number of jeans and/or cell phones that can be produced according to the
inputs to the production process. In this sense, these combinations are efficient and the
PPF, therefore, represents the “best practice” firms in the economy. In contrast, a
production combination represented by a point inside the PPF curve, say B, does not
utilize all the available resources for economic production; With some resources
remaining idle, this production option is considered inefficient.
Economic efficiency is boosted in a static sense (static efficiency) if firms move
from inside the production possibility frontier, say point B, toward the frontier itself, to
point E’. An improvement in economic efficiency of this type could lead to a one-time
increase in income but it would not arrest the tendency toward decreasing returns. This
drift toward decreasing returns is one reason that richer economies tend to grow more
slowly than some poorer economies. There are, of course, many other factors involved
in growth, which is why many poor countries, particularly in Africa and Latin America,
have also experienced slow or even negative growth in per-capita income
Improvements in economic efficiency can take place in a number of ways,
including the move toward best practice through better management and organization.
This could be done by implementing better inventory-control measures, better relations
between management and labor, new methods of organizing the way products are
assembled (within the existing capital structure and labor-force configurations), and so
on.
By contrast with static efficiency, dynamic efficiency takes place when there is
economic growth and the scale of production increases (scale efficiencies), or
production shifts from a low productivity sector to a more productive sector. In Figure
3.1b, this is represented by an outward shift of the PPF curve (the dotted line).
In Asia, much of the dynamic efficiency resulted from a shift from the less
efficient agricultural sector to a more efficient industry. Such inter-industry shifts usually
take place quickly when an economy is growing rapidly. Dynamic efficiency can also
result from new innovations and inventions which boost total factor productivity. It can
also be due to more effective marketing and distribution arrangements, sometimes with
foreign outlets. Large-scale operations also allow bulk purchasing and quantity
discounts that are unavailable to smaller-scale operations. Many multinational firms also
use different production sites to manufacture different components of a product in order
to take advantage of lower costs. These components are then shipped to other
locations where they are assembled and delivered to buyers. Since dynamic efficiency
leads to an outward shift of the production possibility frontier, it leads to a higher level of
output for the same level of capital and labor inputs. Dynamic efficiency may also
involve the use of new technology and innovations as old capital equipment is replaced
and older workers are either replaced or retrained.
Technical Progress
As noted above, there are two kinds of technical progress or innovation that can
be achieved by an economy. Embodied technical progress has to do with the changing
nature of the inputs into the production process. These would include more highly
skilled and computer-literate workers, or less stressed and more congenial workers, or
the installation of new innovations in capital equipment. Disembodied technical progress,
on the other hand, relates to the way factors are combined together in the workplace,
such as management or organizational innovations. This type of technical progress
would be contained in the residual, A, in Equation Y= f(K, L, A) and would arise from the
way in which factors are combined together within the firm and the industry.
Practically, it is unlikely that all the embodied technical progress will be captured
in the measures of labor and capital. Usually, it is hard to get good estimates of the
capital stock as we tend to rely on investment figures to measure the increment to
capital. These f1gures are measured in a monetary unit and therefore do not tell much
about the amount of new innovation or technology contained in this new capital.
Similarly, labor input is usually measured in terms of man-hours or man-years worked.
However, new, more highly trained and educated workers enter the workforce all
the time and older workers retire. These figures are not ordinarily used to construct a
new labor series each year that reflects this higher embodiment of education and skill
into the hours or years worked. There are, nevertheless, attempts to use a range of
educational attainment variables to measure these labor-force effects separately. There
have also been attempts to measure what are called vintage production function that is,
production functions which assume that each year has a new vintage of capital that has
higher innate productivity than do capital investments in previous years. By constructing
a vintage capital model, some economists have been able to reduce quite substantially
the size of the residual, A, in the neoclassical production in Equation Y= f(K, L, A).
However, similar attempts to construct vintage labor production functions have not been
widely made, primarily because people, unlike capital, can increase their productivity
during their lifetime. Therefore, it is unrealistic to assume that each new cohort of
graduates is more qualified than older workers. Thus, in practice, the residual term will
probably contain elements of both disembodied and embodied technical progress.
In growth accounting, the shares of the different factors of production are
assumed to be known and are not estimated as they would be in, say, a Cobb-Douglas
 constant elasticity of substitution, or variable elasticity of substitution model. These
growth accounting models assume that the shares of labor and capital in the national
accounts are marginal products of these factors and are simply added to the factors
contributing to output. The contribution of other factors, such as education and
technological innovation, can also be incorporated by constructing a new series or by
adjusting the existing series. For example, the labor input can be adjusted by multiplying
the labor series by an index of rising educational attainment over time, or by introducing
a new factor of production, such as education, and measuring its separate contribution
to output.
Growth accounting is useful because it is a shorthand method for assessing
technical progress. It does not require calculating a production function, which can often
be complicated by the lack of reliable information on capital stock and labor supply, and
difficulties in empirical estimation.          
GROWTH THEORIES
 

KEYNESIAN THEORY This model stresses the

accumulation of capital. They include Rostow’s
(1960) stages of growth model and the Harrod-
Domar growth model (see Harrod, 1939; and
Domar, 1946) which will be discussed below.
Growth among countries using these models
could easily diverge. The models do not explicitly
consider the law of diminishing returns to capital
which can take effect as growth proceeds. In this
sense, they are not particularly realistic.
The Keynesian Growth Theory and the Harrod-Domar Model
     It is a classical Keynesian model of economic growth that is used in
development economics to explain an economy’s growth rate in terms of the level of
saving and productivity of capital.
 
     The Harrod-Domar (1939, 1946) model is the simplest macroeconomic model.
It begins with the assumption that saving is a constant proportion of income. We first
define income Y as the sum of consumption C and saving S, and that saving equals
investment.
The Harrod-Domar model of growth seeks to explain two (2) basic questions relating
to growth problems of developed countries. They are:

1.      What are the requirements to maintain steady rate of growth of full

employment income without inflation and deflation?
2.      Is long run full employment equilibrium of a developed economy possible
without secular stagnation or secular inflation?
 This model provides gainful suggestions to above questions:
Regarding steady rate of growth of full employment income, Harrod_Domar model
conveys that rate of investment should increase at a rate equal to the proportion
between marginal propensity to save and capital output ratio.
As regards second question, Harrod-Domar are of the view that it is difficult to
maintain steady rate of growth of full employment in a capitalist economy. There are
possibilities of secular inflation or secular deflation in the capitalist economy.
The Harrod Domar Model suggests that the rate of economic growth depends on two things:

1. Level of Savings (higher savings enable higher investment)

2. Capital-Output Ratio. A lower capital-output ratio means investment is more
efficient and the growth rate will be higher.

RATE OF ECONOMIC GROWTH = LVL OF SAVINGS / CAPITAL OUTPUT RATIO

 Level of savings. Higher savings enable greater investment in capital stock
 The marginal efficiency of capital. This refers to the productivity of investment,
e.g. if machines costing $30 million increase output by $10 million. The capital-output
ratio is 3
 Depreciation – old capital wearing out.
 

Three kinds of Growth according to Harrod-Domar:

1. Warranted Growth Rate – also known as “full-capacity” growth rate

Roy Harrod introduced a concept known as the warranted growth rate.

 This is the growth rate at which all saving is absorbed into investment. (e.g. $80
of saving = $80 of investment.
 Let us assume, the saving rate is 10% and the capital-output ratio is 4. In other
words, $10 of investment increases output by $2.5.
 In this case, the economy’s warranted growth rate is 2.5 percent (ten divided by
four).
 This is the growth rate at which the ratio of capital to output would stay constant
at four.
 

2.The Natural Growth Rate

 The natural growth rate is the rate of economic growth required to maintain full
employment.
 If the labour force grows at 3 percent per year, then to maintain full employment,
the economy’s annual growth rate must be 3 percent.
 This assumes no change in labour productivity which is unrealistic.
 

3.Actual Growth
     It is determined by the actual rate of savings and investment in the country. In
other words, it can be defined as the ratio of change in income to the total income in the
given period.
Importance of Harrod-Domar
It is argued that in developing countries low rates of economic growth and development
are linked to low saving rates.

This creates a vicious cycle of low investment, low output and low savings. To boost
economic growth rates, it is necessary to increase savings either domestically or from abroad.
Higher savings create a virtuous circle of self-sustaining economic growth.

 
Impact of increasing capital
The transfer of capital to developing economies should enable higher growth,
which in turn will lead to higher savings and growth will become more self-sustaining.

The Main points of the Harrod-Domar Analysis

1.     Investment is the central variable of stable growth and it plays a double

role; on the one hand, it generates income and on the other hand, it
creates productive capacity.

2.     The increased capacity arising from investment can result in greater

output or greater unemployment depending on the behavior of income.

3.     Conditions concerning the behavior of income can be expressed in

terms of growth rates and equality between the three growth rates can
ensure full employment of labor and full utilization of capital stock.

4.     These conditions, however, specify only a steady-state growth. The

actual growth rate may differ from the warranted growth rate. If the actual
growth rate is greater than the warranted rate of growth, the economy will
experience cumulative inflation. If the actual growth rate is less than the
warranted growth rate, the economy will slide towards cumulative inflation.
 If the actual growth rate is less than the warranted growth rate, the
economy will slide towards cumulative deflation.

5.     Business cycles are viewed as deviations from the path of steady

growth. These deviations cannot go on working indefinitely. These are
constrained by upper and lower limits, the full employment ceiling acts as
an upper limit and effective demand composed of autonomous investment
and consumption acts as the lower limit. The actual growth rate fluctuates
between these two limits.

Criticisms of Harrod-Domar Model

 Developing countries find it difficult to increase saving. Increasing savings ratios

may be inappropriate when you are struggling to get enough food to eat.
 Harrod based his model on looking at industrialised countries post-depression
years. He later came to repudiate his model because he felt it did not provide a model
for long-term growth rates.
 The model ignores factors such as labour productivity, technological innovation
and levels of corruption. The Harrod-Domar is at best an oversimplification of complex
factors which go into economic growth.
 There are examples of countries who have experienced rapid growth rates
despite a lack of savings, such as Thailand.
 It assumes the existences of a reliable finance and transport system. Often the
problem for developing countries is a lack of investment in these areas.
 Increasing capital stock can lead to diminishing returns. Domar was writing
during the aftermath of the Great Depression where he could assume there would
always be surplus labour willing to use the machines, but, in practice, this is not the
case.
 The Model explains boom and bust cycles through the importance of capital,
(see accelerator theory) However, in practice businesses are influenced by many things
other than capital such as expectations.
 Harrod assumed there was no reason for the actual growth to equal natural
growth and that an economy had no tendency to full employment. However, this was
based on the assumption of wages being fixed.
 The difficulty of influencing saving levels. In developing economies it can be
difficult to increase savings ratios – because of widespread poverty.
 The effectiveness of foreign capital flows can vary. In the 1970s and 80s many
developing economies borrowed from abroad, this led to an inflow of foreign capital
however, there was a lack of skilled labour to make effective use of capital. This led to
very high capital-output ratios (poor productivity) and growth rates didn’t increase
significantly. However, developing economies were left with high debt repayments and
when interest rates rose, a large proportion of national savings was diverted to paying
debt repayments.
 Economic development implies much more than just economic growth. For
example, who benefits from growth? does higher national income filter through to
improved health care and education. It depends on how the capital is used.
 
Definition of the Accelerator Effect
The accelerator effect states that investment levels are related the rate of change
of GDP. Thus an increase in the rate of economic growth will cause a correspondingly
larger increase in the level of investment. But, a fall in the rate of economic growth will
cause a fall in investment levels.

SOLOW OR NEOCLASSICAL THEORY These models stress the neoclassical

economic principle that factors of production should be paid the value of their marginal
products. In these models, the law of diminishing returns can operate and there is
mobility of factors to seek their highest return. These models have all been developed
on the basis of the Solow-Swan (1956) model. They were favored by most mainstream
economists for more than thirty years-from the early 1960s or late 1950s when the
Solow model was first published until quite recently. These models show a convergence
in growth among countries and also imply that there will be a slowdown in growth in the
absence of technical progress as a result of diminishing returns.

What is the Solow Growth Model?

 
The Solow Growth Model is an exogenous model of economic growth that
analyzes changes in the level of output in an economy over time as a result of changes
in the population growth rate, the savings rate, and the rate of technological progress.
 
The Solow Growth Model, developed by Nobel Prize-winning economist Robert Solow,
was the first neoclassical growth model and was built upon the Keynesian Harrod-
Domar model. The Solow model is the basis for the modern theory of economic growth.
Simplified Representation of the Solow Growth Model
Below is a simplified representation of the Solow Model.

Assumptions:

1. The population grows at a constant rate g. Therefore, current population (represented by

N) and future population (represented by N’) are linked through the population growth equation
N’ = N(1+g). If the current population is 100 and the growth rate of population is 2%, the future
population is 102.
2. All consumers in the economy save a constant proportion, ‘s’, of their incomes and
consume the rest. Therefore, consumption (represented by C) and output (represented by Y)
are linked through the consumption equation C= (1+s)Y. If a consumer earns 100 units of output
 as income and the savings rate is 40%, then the consumer consumes 60 units and saves 40
units.
3. All firms in the economy produce output using the same production technology that
takes in capital and labor as inputs. Therefore, the level of output (represented by Y), the level
of capital (represented by K), and the level of labor (represented by L) are all linked through the
production function equation Y = aF(K,L).
The Solow Growth Model assumes that the production function exhibits constant-returns-to-
scale (CRS). Under such an assumption, if we double the level of capital stock and double the
level of labor, we exactly double the level of output. As a result, much of the mathematical
analysis of the Solow model focuses on output per worker and capital per worker instead of
aggregate output and aggregate capital stock.

1. Present capital stock (represented by K), future capital stock (represented by K’), the
rate of capital depreciation (represented by d), and level of capital investment (represented by I)
are linked through the capital accumulation equation K’= K(1-d) + I.
Implications of the Solow Growth Model
There is no growth in the long term. If countries have the same g (population growth
rate), s (savings rate), and d (capital depreciation rate), then they have the same steady state,
so they will converge, i.e., the Solow Growth Model predicts conditional convergence. Along this
convergence path, a poorer country grows faster.
Countries with different saving rates have different steady states, and they will not
converge, i.e. the Solow Growth Model does not predict absolute convergence. When saving
rates are different, growth is not always higher in a country with lower initial capital stock.
Source:https://corporatefinanceinstitute.com/resources/knowledge/economics/solow-growth-model/

POWER-BALANCE THEORY These models stress international power balance

as an important factor in development, including the terms and patterns of trade which
tend to keep some countries poor while other countries get richer. In one sense, the
international power-balance model can be considered as a subclass of the neoclassical
model where there is a lack of factor mobility in international trade.
In addition, these theories, which were popular when North-South issues were
being stressed, were based on the assumption that the poor “southern” economies were
being exploited by the rich industrial “northern” countries. In these models, the poor
countries export raw materials to the industrial countries in exchange for industrial
goods. Because the terms of trade (that is, the price of raw materials vis-a-vis
manufactured goods) tend to deteriorate over time, the power balance theories assert
that the poor countries have to export more and more raw materials in order to keep
from slipping backward. As a result, their development is retarded. The development of
industrial capacity in East and Southeast Asia, and in some Latin American countries,
has caused these theories. to become discredited generally, although there are
elements of truth in this paradigm in Africa, where raw materials are still the main
exports. These theories also assume that when incomes are low, these countries will
not be able to save much. Thus, the assumption is that the saving rate is not
independent of income, as in the Harrod-Domar model. In addition, because of poverty,
it is difficult to achieve high productivity in agriculture or even to improve productivity in
agriculture.
Balance of power (International relations) (Source:https://www.britannica.com/topic/balance-of-power)

Balance of power, in international relations, the posture and policy of a nation or

group of nations protecting itself against another nation or group of nations by matching
its power against the power of the other side. States can pursue a policy of balance of
power in two ways: by increasing their own power, as when engaging in an armaments
race or in the competitive acquisition of territory; or by adding to their own power that of
other states, as when embarking upon a policy of alliances.

The term balance of power came into use to denote the power relationships in

the European state system from the end of the Napoleonic Wars to World War I. Within
the European balance of power, Great Britain played the role of the “balancer,” or
“holder of the balance.” It was not permanently identified with the policies of any
European nation, and it would throw its weight at one time on one side, at another time
on another side, guided largely by one consideration—the maintenance of the balance
itself. Naval supremacy and its virtual immunity from foreign invasion enabled Great
Britain to perform this function, which made the European balance of power both flexible
and stable.

STRUCTURALTHEORY These models emphasize the shifts in resources

between different sectors on the supply side. These theories discuss the transition from
labor-intensive agriculture, which relies on traditional, low-productivity farming
techniques, to modern, high productivity industries which have benefited from
innovation and more intensive use of capital and technology.
The structuralist approach models economic growth as a process of shifts in
resources among sectors. It stresses rigidities that hinder this shift in resources and it
studies how the shift in output among different sectors takes place over time as
development progresses. In particular, a systematic shift in output has been observed in
the process of development in the industrial countries, as well as in many developing
countries. This process involves a decline in agriculture’s contribution to GDP, an
increase in industrial output up to a point when it too begins to decline, and finally an
increase in the component of services income as a share of GDP, which has not yet
begun to decline. As a result, very rich countries, such as the United States, have a very
large proportion of GDP in the services sector-as much as 60 to 70 percent. Agriculture
contributes a very small part in terms of value added to GDP, perhaps 6 percent, while
industry makes up the difference. In rapidly-growing industrializing countries, the share
of industry would be larger and still growing, while agriculture would be large but falling.
Although services would be rising, it would have a smaller share in GDP. A very poor
country would have most of its resources in agriculture and very little in services or
manufacturing.
The source of rapid growth, from the structuralist point of view is manufacturing.
Productivity increases faster in manufacturing and remains high for many years as
technological developments are made or copied from other countries. The reason that
industrial countries grow slowly, from this perspective, is that productivity in the services
sector has historically been low and has not grown as fast as productivity in
manufacturing.
Although this may be changing as a result of the technological revolution, leading
to higher rates of growth, this “new productivity revolution” has not yet been firmly
established. Lower growth in the services sector is still a drag on the economic
performance of the industrial countries. Another contributing factor to slower growth in
the industrial countries is that their rates of saving and investment are lower than in
rapidly growing poorer countries. Therefore, the industrial countries have to depend to a
greater extent on TFP and new innovations, as well as human capital development
through education for their growth.
 
The Lewis-Fei-Ranis Model This model is under the structuralist theory. A very
well-known theory of development is the so-called Lewis Fei-Ranis (LFR) model (Lewis,
1954; and Fei and Ranis, 1961). There are elements of this model which are very
important to understanding the pattern of development in many countries. It tries to
explain how the process of industrialization takes place and how inefficiencies can
arise. There are two sectors in the LFR model: a modern sector and a traditional sector.
The former is primarily based in cities and the latter in the countryside. The rural sector
has low capital accumulation and low labor skill. Its productivity and earnings
capabilities are also very low. The modern sector has high productivity and pays higher
wages. Labor thus moves from the countryside to the city to take advantage of wage
differentials.
Fei–Ranis model of economic growth (source: https://en.wikipedia.org/wiki/Fei
%E2%80%93Ranis_model_of_economic_growth)

The Fei–Ranis model of economic growth is a dualism model in developmental

economics or welfare economics that has been developed by John C. H.
Fei and Gustav Ranis and can be understood as an extension of the Lewis model. It is
also known as the Surplus Labor model. It recognizes the presence of a dual
economy comprising both the modern and the primitive sector and takes the economic
situation of unemployment and underemployment of resources into account, unlike
many other growth models that consider underdeveloped countries to be homogenous
in nature. According to this theory, the primitive sector consists of the existing
agricultural sector in the economy, and the modern sector is the rapidly emerging but
small industrial sector. Both the sectors co-exist in the economy, wherein lies the crux of
the development problem. Development can be brought about only by a complete shift
in the focal point of progress from the agricultural to the industrial economy, such that
there is augmentation of industrial output. This is done by transfer of labor from the
agricultural sector to the industrial one, showing that underdeveloped countries do not
suffer from constraints of labor supply. At the same time, growth in the agricultural
sector must not be negligible and its output should be sufficient to support the whole
economy with food and raw materials. Like in the Harrod–Domar model, saving and
investment become the driving forces when it comes to economic development of
underdeveloped countries.
Fei–Ranis model of economic growth has been criticized on multiple grounds,
although if the model is accepted, then it will have a significant theoretical and policy
implications on the underdeveloped countries' efforts towards development and on the
persisting controversial statements regarding the balanced vs. unbalanced growth
debate.
    It has been asserted that Fei and Ranis did not have a clear understanding of the
sluggish economic situation prevailing in the developing countries. If they had thoroughly
scrutinized the existing nature and causes of it, they would have found that the existing
agricultural backwardness was due to the institutional structure, primarily the system
of feudalismthat prevailed.
    Fei and Ranis say, "It has been argued that money is not a simple substitute
for physical capitalin an aggregate production function. There are reasons to believe that
the relationship between money and physical capital could be complementary to one
another at some stage of economic development, to the extent that credit policies could play
an important part in easing bottlenecks on the growth of agriculture and industry." This
indicates that in the process of development they neglect the role of money and prices.
They fail to differ between wage labor and household labor, which is a significant distinction
for evaluating prices of dualistic development in an underdeveloped economy.
     Fei and Ranis assume that MPPLis zero during the early phases of economic
development, which has been criticized by Harry T.Oshima and some others on the grounds
that MPPL of labor is zero only if the agricultural population is very large, and if it is very
large, some of that labor will shift to cities in search of jobs. In the short run, this section of
labor that has shifted to the cities remains unemployed, but over the long run it is either
absorbed by the informal sector, or it returns to the villages and attempts to bring more
marginal land into cultivation. They have also neglected seasonal unemployment, which
occurs due to seasonal change in labor demand and is not permanent
 
NEW GROWTH THEORY The most recent growth theories, simply called “new
growth theories” try to endogenize technical progress and make use of assumptions of
increasing returns to scale and positive externalities. These assumptions contrast
sharply with the neoclassical model which stresses diminishing returns and a slowdown
of growth to a steady-state rate.
The new growth theory has been developed in the last decade by a number of
younger economists who became dissatisfied with the Solow-Swan (1956) model. The
new growth theory attempts to endogenize technical change by using external
economies and spillovers. These operate on the basis of beneficial effects which new
technology and higher levels of education have on other sectors of the economy. These
externalities help to generate increasing returns to scale and drive the growth process
to higher levels of income, instead of slowing growth through diminishing returns. One
of the important features of this model is the mechanism by which technology is
transferred from one firm to another within an industry in a single country and then
across international borders. One group of economists working on this model contends
that the development of new technology in industrial countries is passed on to other
countries quite slowly so that there is little tendency for convergence to take place.
Others argue that the process is swifter (Barro and Sala-I Martin, 1995; and Grossman
and Helpman, 1991).
New Growth Theory
(Source:https://www.economicsonline.co.uk/global_economics/new_growth_theory.html)

 
New Growth theory is closely associated with American economist, Paul Romer. A
central proposition of New Growth theory is that, unlike land and capital, knowledge is not
subject to diminishing returns.

The importance of knowledge

Indeed, a focus on the development of knowledge is seen as a key driver of economic
development. The implication is that, in order to develop, economies should move away from an
exclusive reliance on physical resources to expanding their knowledge base, and support the
institutions that help develop and share knowledge.

Governments should invest in knowledge because individuals and firms do not

necessarily have private incentives to do so. For example, while knowledge is a merit good,
and acquiring it does not deny anyone else that knowledge (the principle of nonrivalry of
knowledge), its usefulness to individuals and firms may be undervalued, and yet knowledge can
generate increasing returns and drive economic growth. Government should, therefore, invest in
human capital, and the development of education and skills. It should also support private
sector research and development and encourage inward investment, which will bring new
knowledge with it.

The role of the public sector

Because ‘public’ investment in social capital is subject to market failure, New Growth
theorists argue that government should allocate resources to compensate for this failure.

Public Utilities and infrastructure

Essential utilities like electricity, gas, and water are natural monopolies, and in many
countries are provided by the public sector. However, if these utilities are under-supplied due to
inadequate public funds, the private sector will suffer and growth will be limited. This is because
the industrial sector relies on energy and water for its production and distribution, without which
it will not produce efficiently or competitively. The accumulation of private capital, therefore,
depends up the correct level of expenditure by government.

Similarly, New Growth theorists argue that government should also finance, or seek
finance for, infrastructure projects, such as road, rail, sea, and air transport. Such projects
involve the creation of quasi-public goods, and the theory of market failure suggests that they
would be ‘under-supplied’ without government. The huge fixed costs and the difficulty of
charging users prevents the private sector supplying, and the state may choose to act like a
producer and financier, and provide necessary legislation for and co-ordination of such projects.
 These projects also generate positive externalities, and as such justify government
involvement. For example, an improved infrastructure increases the likelihood of tourist revenue
as well as reducing production costs.