NAME: TAHIR ALI WAGGAN

FATHER’S NAME: ABDUL FATAH WAGGAN

CLASS: MPA FINAL

ROLL: MPA/2K18/34

SUBJECT: DEVELOPMENT ECONOMICS

TOPIC: VICIOUS CIRCLE OF POVERTY

ASSIGNED TO: SIR AYAZ AHMED CHACHAR

DEPT: PUBLIC ADMINISTRATION
Essay on the Vicious Circle of Poverty | Economics
In this essay we will discuss about the vicious circle of poverty.
Most widely propagated explanation why poor underdeveloped countries have
failed to grow economically is that they are trapped in vicious circles of poverty.
These vicious circles of poverty operate both on the supply and demand sides of
capital formation. Supply side of capital formation refers to saving required to
accelerate capital formation in order to raise productivity and per capita income.
On the other hand, demand side of capital formation refers to inducement to
invest (that is, investment demand) which depends on the size of market (i.e.;
level of demand) which is small in the underdeveloped countries. Ragnar Nurkse
in his now well-known work’ on underdeveloped countries attributed the
persistence of poverty in them to these vicious circles of poverty and suggested
policies to break these vicious circles. Both these vicious circles take poverty as
their starting point.

3 Major Causes of Vicious Circle of Poverty: -

However, the reasons of vicious circle of poverty can be classified into three
groups:
(a) Supply side of vicious circle.
(b) Demand side of vicious circle.
(c) Vicious Circle of Market Imperfections.

Following are the types of vicious circles of poverty:

1. Vicious Circle of Poverty (Supply-Side):
In the underdeveloped countries the rate of savings has been very low. In other
words, these countries save a very small proportion of their current national
income. In India the level of gross domestic savings has increased to about 30% of
the national income in recent years only because of the stimulus provided by the
planned development under the Five-Year Plans. The level of savings in
underdeveloped countries is very small mainly because their level of national
income and per capita income is very low. As a result, much of the income is
consumed and little is left for investment purposes.
Thus, underdeveloped countries are caught in the vicious circle of poverty. Because
of the low level of income, the capacity to save is very small. Since the capacity to
save is small, rate of saving and investment must be low. Investment being low
leads to a lack of capital per head. Because there is small amount of capital per
head, the productivity of the people or real income per head will be low. Thus, the
vicious circle is complete. Vicious circle of poverty on the supply-side of capital
formation is illustrated in Fig. 5.1.

Fig. 5.1. Vicious circle of poverty on the supply-side of capital formation

In a slightly different way Professor Hicks describes the working of vicious circle in
an under developed country as thus, “Productive power can be used either for
the production of consumption goods or of investment goods. Now when the
average productivity of a community is low, it will have the greatest difficulty in
producing enough consumption goods to satisfy the basic necessities of life; so it
will have little productive power to spare for the production of investment goods.
Countries which are in this position are involved in a vicious circle. A large supply
of capital equipment would enable them to escape from the toils of
overpopulation but they are too deeply caught in those toils to be able to produce
that equipment for themselves. Thus, they cannot escape without assistance from
outside.”
Apart from the low level of per capita income, the low relative level of real
income in underdeveloped countries as compared with the advanced and rich
countries also makes their capacity to save very small. The great and growing
inequalities between the income levels and, therefore, living standards of
different countries, combined with increasing awareness of these inequalities
have pushed up the general propensity to consume of people in the
underdeveloped countries and, have, therefore, reduced their capacity to save.
The tendency of the people of underdeveloped countries to copy the higher levels
of consumption standards prevailing in the advanced countries has been called
“International demonstration effect” by Nurkse. This also explains why the rate of
saving and capital formation in developing countries has been low which the main
cause of their underdevelopment is.
It may be noted that Nurkse used the idea of vicious circle of poverty to advocate
that with adequate foreign aid or foreign direct investment the underdeveloped
countries could succeed in breaking the vicious circle of poverty. He argued that
with injection of foreign capital, productivity of labor would rise which would lead
to higher incomes and eventually will generate higher savings. With higher
savings made possible by injection of foreign capital, rate of capital formation will
be raised which will help to break the vicious circle of poverty. Furthermore,
higher incomes generated by greater investment with foreign capital would also
increase aggregate demand in the economy which will stimulate capital formation
by creating profitable investment opportunities.
A Critique:
However, the above thesis of Nurkse is questionable. If this thesis were valid, then
it would be difficult to explain the development and capital formation in the
present-day developing countries like China (until 1980s) and India which also
started with low per capita income and many of them grew economically without
much foreign aid. Of course, foreign aid and foreign investment can make an
important contribution to economic development of the underdeveloped
countries. What is being stressed here is that higher rate of capital formation and
economic growth can be achieved without much inflow of foreign capital.
2. Vicious Circle of Poverty (Demand Side):
An important reason why investment or capital formation is low has been
advanced by Nurkse. He argues that just as division of labor is limited by the size
of the market, inducement to invest is also limited by the size of the market. The
size of the market in underdeveloped countries is very small due to the low per
capita income of the people, and the income per capita is low because there is a
use of meagre amount of capital in the production processes in underdeveloped
countries. The use of capital equipment in the production of goods and services
for the domestic market is discouraged by the small size of the market.
Thus, a vicious circle operates on the demand-side of capital formation. To quote
Nurkse, “The inducement to invest may be low because of the small buying power
of the people, which is due to their small real income, which again is due to low
productivity. The low level of productivity, however, is a result of the small
amount of capital used in production, which its turn may be caused at least partly
by the small inducement to invest.” The vicious circle of poverty operating on the
demand side is illustrated in Fig. 5.2.

From above it is concluded that underdeveloped countries have remained poor

and economically backward because of low rate of capital accumulation as
compared with the growth of population. As a result, capital per worker is very
small and therefore his productivity is low. This, as seen above, gives rise to the
vicious circle of poverty which is an important cause of persistent
underdevelopment.
If the underdeveloped countries want to accelerate the rate of capital
accumulation so as to achieve rapid economic growth, then the vicious circles of
poverty operating on the supply and demand sides of capital formation have to
be broken. Once the vicious circles are broken and a country starts developing,
economic growth becomes cumulative and these circles become beneficent.
A Critique:
However, there are also flaws in the argument for the operation of vicious circle
of poverty on the demand-side of capital formation. In this regard, the argument
of Nurkse that limited size of the market is responsible for low rate of investment
in poor underdeveloped countries is not entirely correct. The relationship
between the limited size of the market and lower investment is based on the
argument that economies of scale in industries are a key feature of their growth
and for big industrial enterprises to produce on a large scale and to be
economically profitable, the size of market, that is level of demand for a product
must be large.

3. Vicious Circle of Market Imperfections:

Meier and Baldwin have described a third vicious circle based on capital
deficiency due to market imperfections. In underdeveloped countries, resources
are underdeveloped and people are economically backward. Existence of market
imperfections prevents optimum allocation and utilization of natural resources
and the result is underdevelopment and this, in turn, leads to economic
backwardness.
The development of natural resources depends upon the character of human
resources. But due to lack of skill and low level of knowledge, natural resources
will remain unutilized, under-utilized and mutualized. In the words of Meier and
Baldwin, “Underdeveloped resources are, therefore, both a consequence and
cause of the backward people… The more economically backward are the people,
the less developed will be natural resources, lesser the development of natural
resources more the people are economically backward.” The vicious circle caused
by Market Imperfections is shown as under.
The vicious circle of poverty is a result of the various vicious circles which were on
the sides of supply of and demand for capital. As a result, capital formation
remains low productivity and low real incomes. Thus, the country is caught in
vicious circles of poverty which are mutually aggravating and it is very difficult to
break them.

Suggestions for Breaking the Vicious Circle of Poverty:

In order to break the vicious circle of poverty and bring about economic growth,
an important thing to be noted is that in underdeveloped countries rate of saving
and investment can be increased without the reduction in consumption. As is well
known, rate of saving in underdeveloped countries is low. With a given rate of
saving and investment, some rate of economic growth and as a result some
increment in income must be occurring in these underdeveloped countries. If out
of this increment in income a proportionately greater part is saved, the rate of
saving of the economy will rise.
For instance, suppose as a result of 15% rate of saving and investment, an
increment in income equal to Rs 100 crore takes place. If out of these Rs 100
crore, a greater part is saved, say 25%, and 75% is consumed, then the rate of
saving will rise above 15%. It should be noted that in this process consumption
will not decline, in fact it will increase by Rs 75 crore, and along with this the rate
of saving will also increase. If the increment in income of Rs 100 crore is wholly
consumed away, the rate of saving will decline.
The saving of Rs 25 crore out of the increment of Rs 100 crore, means that the
marginal rate of saving is 25%, which is higher than the previous average rate of
saving i.e., 15% which means average rate of saving will go up. The sum and
substance of the argument is that in underdeveloped countries, the rate of
investment and capital formation can be stepped up even without reduction in
the consumption of the people, provided the marginal rate of saving is kept
higher than the average rate of saving even though the current average rate of
saving is low.
In this way, the rate of investment can be stepped up and standards of living of
the people can be raised in future without the reduction in present consumption.
This is how the vicious circle of poverty operating on the supply side of the capital
formation can be broken.
As explained before, according to Nurkse, vicious circle of poverty also operates
on the demand side of capital formation. To break the vicious circle on the
demand side, Nurkse suggested ‘the strategy of balanced growth’. According to
this, if investment is made in an individual industry, it is likely to fail owing to low
income and limited size of the market. This is because investment in an individual
industry does not raise the incomes of the people outside that industry.
If the incomes of the people outside that industry do not rise, the demand for the
product of that industry will not increase adequately to buy the larger production
of the industry made possible by larger investment in it. Thus, more investment in
one individual industry makes possible large increase in production.
But since the incomes of the people are low, the demand for the product of the
firms in which more investment has been made, will not rise and therefore
productive capacity of the firms will not be fully utilized. As a result of this, larger
investment in them may not be profitable. This would have an adverse effect on
the inducement to invest in the industry.
But, according to Nurkse, if investment is made in several industries
simultaneously, then the workers employed in various industries will become
consumers of each other’s products, and will thus create demand for one
another. The simultaneous investment in a large number of industries has been
called balanced growth. The balanced growth, i.e., simultaneous investment in a
large number of industries creates its own demand. Thus, according to Nurkse,
through the strategy of balanced growth vicious circle of poverty operating on the
demand side of capital formation can be broken.
Suggestions for Removal of Poverty from India
(i) Population Control:
Population in India has been increasing rapidly. Growth rate of population is 1.8%.
For removal of poverty the growth rate of population should be lowered.

(ii) Increase in Employment:

Special measures should be taken to solve the problems of unemployment and
disguised unemployment. Agriculture should be developed. Small scale and
cottage industries should be developed in rural areas to generate employment.

(iii) Equal distribution of Income:

Mere increase in production and control on population growth will not remove
poverty in India. It is necessary that inequality in the distribution of income should
be reduced.

(iv) Regional poverty:

In States like Orissa, Nagaland, U.P and Bihar etc. the percentage of the poor to
the total population is high. Govt. should give special concession for investment in
these regions. More PSU’s should be established in these states.

(v) Problem of Distribution:

The public distribution system (PDS) should be strengthened to remove poverty.
Poor section should get food grains at subsidized rates and in ample quantity.

(vi) Fulfillment of minimum needs of the Poor:

Govt. should take suitable steps to meet minimum needs of the poor e.g., supply
of drinking water and provision of primary health centers and primary education.
(vii) Increase in the productivity of the Poor:
To remove poverty, it is necessary to increase productivity of the poor. The poor
should be given more employment. More investment should be made in public
and private sectors to generate employment.

(viii) Changes in techniques of Production:

India should adopt labor intensive techniques of production. We should have
technical development in our economy in such a way that labor resources could
be fully employed.

(ix) Stability in Price Level:

Stability in prices helps to remove poverty. If prices continue to rise, the poor will
become poorer. So, Govt. should do it best to keep the prices under control.

(x) Development of Agriculture:

The agriculture should be developed to remove poverty. Rapid rate of growth of
agriculture production will help to remove urban as well as rural poverty.
Agriculture should be mechanized and modernized. Marginal farmers should be
given financial assistance.

(xi) Increase in the rate of growth:

Slow rate of growth is the main cause of poverty. So, growth rate must be
accelerated. In 2003-04 the growth rate has been 6.5% despite that 26% of
population remains below poverty line.