ECONOMIC DEVELOPMENT

© angelica garcia

THIS REVIEWER IS NOT FOR SALE.

Resources: Factors of Production

1. Land
- Natural resources
- The payment for Land is RENT

2. Labor
- Human resources
- The payment for Labor is WAGES

3. Capital (a product of Investment)

- Tools, machines, factories
- The payment for Capital is INTEREST

4. Entrepreneurship
- The special ability of risk-takers to combine land, labor and capital in new ways in order to
make profit
- The payment for Entrepreneurship is PROFIT

Scarcity
• People have unlimited wants but the resources to satisfy those wants are scarce. Therefore, we
must make choices about how to use our scarce resources. We face trade-offs when it comes
to using available resources.
• Ex. Assume flour is a scarce resource: 3 cups of flour can be used to make a loaf of bread or a
cake, but the 3 cups cannot be used to make both.

Opportunity Cost
• Once a resource or factor of production has been put to productive use an opportunity cost is
incurred.
• Opportunity cost is the next best alternative use for a resource.
• Ex. If the 3 cups of flour are used to bake bread, then the opportunity cost is the cake that could
also have been baked with the 3 cups of flour.
• No matter what we do with our time or resources, we always incur opportunity cost. TINSTAAFL
– There is no such thing as free lunch (Everything has a cost).

Production Possibilities Curve

• A graph showing all of the possible combinations of
output for an economy fully employing all of its
resources in producing 2 goods.
• A graph that shows the combinations of output that
the economy can possibly produce given the
available factors of production and the available
production technology.
• Assumptions:
a. Full employment
b. Fixed resources
c. Fixed technology
d. Two goods
• Concave – increasing opportunity cost
• Convex – decreasing opportunity cost
 Individual’s Economizing Problem
1. Limited Income
2. Unlimited Wants

Budget Line
- Tradeoffs & opportunity costs
- Make best choice possible
- Change in income

Example of a Budget Line

PPF Points: Efficient, Inefficient, & Impossible

• An outcome is said to be efficient if the economy is
getting all it can from the scarce resources it has
available.
• Points On (rather than inside) the production possibilities
frontier represents efficient levels of production. When
the economy is producing at such a point, there is no
way to produce more of one good without producing
less of the other.
• Points Inside. Represents an inefficient outcome. For
some reason, perhaps widespread unemployment, the
economy is producing less than it could from the current available resources.
• Points Outside. Represents the future and are not currently possible with the resources available,
or impossible.

Law of Increasing Opportunity Cost

• As the production of a particular good increases, the opportunity cost of producing an
additional unit increases.
• Rationale: Economic resources are not completely adaptable to alternative uses. Many
resources are better at producing one type of good than at producing others.

Sample Scenario: Law of Increasing Opportunity Cost

Pizzas and Robots: Assume Italy was producing 200 pizzas and 0 robots. Surely, many of the resources
(land, labor and capital) being used to make pizzas would be better suited to making robots. As Italy
starts making its first two robots it has to give up very few pizzas, since only those resources that are
suited for robot production will be used. At first, 2 robots "cost" Italy only 5 pizzas. But as the country
makes more and more robots, the opportunity cost increases, because at some point pizza makers will
have to build robots. As Italy approaches 10 robots, the opportunity cost of the last two robots is 130
pizzas, as resources better suited for pizza production are employed in robot factories.

Guide Questions
1. Which point(s) are attainable and desirable? Points on the PPC (A,
B and C) are attainable through full employment, and thus
desirable because they represent efficient use of Italy's resources.
2. Which point(s) are attainable but not desirable? Point D is inside
the PPC, thus represents inefficient use of resources, and most
likely high unemployment, and is thus undesirable.
3. Which point(s) are unattainable? Is this point desirable? Point E
is beyond Italy's production possibilities and is thus
unattainable. It is desirable because it represents greater
consumption of both pizzas and robots.
4. Which point will mean more consumption in the future? Point A
represents more consumption in the future, because Robots are a
capital good, used to make other products for consumption. If Italy
produces more robots now, it may mean more consumer goods in
the future.
5. Which point means more consumption now? Point C because pizza is a consumer good.
Households don't buy and use robots, but they do like to eat pizzas.
6. Why is the PPC bowed outwards? The Law of Increasing Opportunity Cost

Convex PPF
• The traditional example of guns and butter makes sense for the increasing opportunity costs
case, the decreasing opportunity costs case would require an example with scale economies,
such as those seen in technology fields or in infrastructure.
• An example would be the production of plane flights or train rides. In each of these industries,
initial capital costs to build the airports or the railroads are very high. But after some are built,
subsequent investments are cheaper due to a network effect. As a result, both industries are
subject to increasing returns, and their combined production frontier can exhibit decreasing
opportunity costs.

Optimal Allocation of Resources

• Marginal Benefit = Marginal Cost (Equilibrium Point)
• Marginal Cost – The opportunity cost of producing one more unit
of a good or service.
- The marginal cost of producing a good increase as more of the
good is produced.
• Marginal Benefit – The benefit that a person receives from
consuming one more unit of a good or service.
 - The marginal benefit from a bottle of water is the number of CDs that people are willing to
forgo to get one more bottle of water.
- Marginal benefit decreases as more bottled water is available.

Demand
• Demand is the desire, willingness, and ability to buy a good or service.
• Supply can refer to one individual consumer or to the total demand of all consumers in the
market (market demand).

Demand Schedule
• A demand schedule is a table that lists the various quantities of a product or service that
someone is willing to buy over a range of possible prices.

Price per Widget ($) Quantity Demanded of Widget per day

$5 2
$4 4
$3 6
$2 8
$1 10

Demand Curve
• The Demand Schedule can be represented by points on a graph.
• The graph lists prices on the vertical axis and quantities demanded on the horizontal axis.
• Each point on the graph shows how many units of the product or service an individual will buy
at a particular price.
• The demand curve is the line that connects these points.
• The demand curve slopes downward.
- This shows that people are normally willing to buy less of a product at a high price and more
at a low price.
- According to the law of demand, quantity demanded and price move in opposite
directions.

Demand Curve for Widgets

$6
Price per Widget

$4

$2 Demand Curve for

Widgets
$0
0 5 10 15
Quantity Demanded of Widgets

Principle of Diminishing Marginal Utility

• We buy products for their utility – the pleasure, usefulness, or satisfaction they give us.
• One reason the demand curve slopes downward is due to diminish marginal utility
• The principle of diminishing marginal utility says that our additional satisfaction tends to go down
as we consume more and more units.
• To make a buying decision, we consider whether the satisfaction we expect to gain is worth the
money we must give up.
Changes in Demand
• Change in the quantity demanded due to a price change occurs ALONG the demand curve.
• Acronym: BITER
1. Buyers (# of) – changes in the number of consumers
2. Income – changes in consumers’ income
3. Tastes – changes in preference or popularity of product/ service
4. Expectations – changes in what consumers expect to happen in the future
5. Related goods – compliments and substitutes
à Substitute goods – a substitute is a product that can be used in the place of another. The
price of the substitute good and demand for the other good are directly related.
à Complementary goods – a compliment is a good that goes well with another good. When
goods are complements, there is an inverse relationship between the price of one and the
demand for the other.

Increase in Demand $6 Decrease in Demand

$6 $5

Price per Widget

Price per Widget

Orginal $4
$4
Demand $3 Original
$2 Curve Demand Curve
New $2 New Demand
$0 Demand Curve
$1
0 5 10 15 Curve
Quantity Demanded of Widets $0
0 Quantity5Demanded of
10Widgets 15

Remember:
• Changes in any of the factors other than price causes the demand curve to shift either:
a. Decrease in Demand shifts to the Left (Less demanded at each price)
b. Increase in Demand shifts to the Right (More demanded at each price)

Supply
• Supply refers to the various quantities of a good or service that producers are willing to sell at
all possible market prices.
• Supply can refer to the output of one producer or to the total output of all producers in the
market (market supply).

Supply Schedule
• A supply schedule is a table that shows the quantities producers are willing to supply at various
prices
Price per Widget ($) Quantity Supplied of Widget per day
$5 10
$4 8
$3 6
$2 4
$1 2

Supply Curve
• A supply schedule can be shown as points on a graph.
• The graph lists prices on the vertical axis and quantities supplied on the horizontal axis.
 • Each point on the graph shows how many units of the product or service a producer (or group
of producers) would willing sell at a particular price.
• The supply curve is the line that connects these points.
• As the price for a good rises, the quantity supplied rises and the quantity demanded falls. As
the price falls, the quantity supplied falls and the quantity demanded rises.
• The law of supply holds that producers will normally offer more for sale at higher prices and less
at lower prices.
• The reason the supply curve slopes upward is due to costs and profit.
- Producers purchase resources and use them to produce output.
à Producers will incur costs as they bid resources away from their alternative uses.
- Businesses provide goods and services hoping to make a profit.
à Profit is the money a business has left over after it covers its costs.
à Businesses try to sell at prices high enough to cover their costs with some profit left over.
à The higher the price for a good, the more profit a business will make after paying the cost
for resources.

Supply Curve for Widgets

$6
Price per Widget

$5
$4
$3
$2 Supply Curve
$1
$0
0 5 10 15
Quantity Supplied of Widgets

Changes in Supply
• Change in the quantity supplied due to a price change occurs ALONG the supply curve
• Supply Curves can also shift in response to the following factors:
1. Subsidies and taxes – government subsides encourage production, while taxes discourage
production
2. Technology – improvements in production increase ability of firms to supply
3. Other goods – businesses consider the price of goods they could be producing
4. Number of sellers – how many firms are in the market
5. Expectations – businesses consider future prices and economic conditions
6. Resource costs – cost to purchase factors of production will influence business decisions

Increase in Supply Decrease in Supply

$6 $6
Price per Widget

Price per Widget

$5 $5
$4 $4
$3 Original Supply $3 Original Supply
Curve Curve
$2 $2
$1 New Supply $1 New Supply
Curve Curve
$0 $0
0 5 10 15 0 5 10 15
Quantities Supplied of Widgets Quantity Supplied of Widgets
Note:
• Changes in any of the factors other than price causes the supply curve to shift either:
a. Decrease in Supply shifts to the Left (Less supplied at each price)
b. Increase in Supply shifts to the Right (More supplied at each price)

Supply and Demand at Work

• Markets bring buyers and sellers together.
• The forces of supply and demand work together in markets to establish prices.
• In our economy, prices form the basis of economic decisions.
• Supply and Demand Schedule can be combined into one chart.

Price per Quantity Demanded Quantity Supplied

Widget ($) of Widget per day of Widget per day Supply and Demand for
$5 2 10 Widgets
$4 4 8
$3 6 6 $6
Price per Widget

$2 8 4 $4 Demand
$1 10 2 $2 Curve
$0 Supply Curve
Surplus 0 5 10 15
• A surplus is the amount by which the quantity
Quantity of Widgets
supplied is higher than the quantity demanded.
• A surplus signal that the price is too high. At that
price, consumers will not buy all of the product that suppliers are willing to supply.
• In a competitive market, a surplus will not last. Sellers will lower their price to sell their goods.
Shortage
• A shortage is the amount by which the quantity demanded is higher than the quantity supplied.
• A shortage signals that the price is too low. At that price, suppliers will not supply all of the
product that consumers are willing to buy.
• In a competitive market, a shortage will not last. Sellers will raise their price.

Equilibrium
• When operating without restriction, our market economy eliminates shortages and surpluses.
• Over time, a surplus forces the price down and a shortage forces the price up until supply and
demand are balanced.
• The point where they achieve balance is the equilibrium price. At this price, neither a surplus nor
a shortage exists.
• Once the market price reaches equilibrium, it tends to stay there until either supply or demand
changes. When that happens, a temporary surplus or shortage occurs until the price adjusts to
reach a new equilibrium price.

Invisible Hand Theory

• Invisible hand framework – perfectly competitive lead individuals to make voluntary choices
that are in society’s interest.
Market Failure
• A market failure occurs when the invisible hand pushes in such a way that individual decisions
do not lead to socially desirable outcomes.
• Any time a market failure exists, there is a reason for possible government intervention into
markets to improve the outcome.
• Because the politics of implementing the solution often leads to further problems, government
intervention may not necessarily improve the situation.

Externalities
• Externalities are the effect of a decision on a third party that is not taken into account by the
decision-maker.
• Externalities can be both positive and negative.

1. Negative externalities
Ø Occur when the effect of a decision on others that is not taken into account by the
decision-maker is detrimental to the third party.
Ø Examples include second-hand smoke, water pollution, and congestion.
Ø Marginal social cost is greater than marginal private cost. [Marginal social cost includes
all the marginal costs borne by society]
Ø Marginal social cost is calculated by adding the negative externalities associated with
production to the marginal private costs of that production.

2. Positive externalities
Ø Occur when the effect of a decision on others that is not taken into account by the
decision-maker is beneficial to others.
Ø Examples include innovation, education, and new business formation.
Ø Private trades can benefit third parties not involved in the trade.
Ø Marginal social benefit equals the marginal private benefit of consuming a good or
service plus the positive externalities resulting from consuming that good or service.
Alternative Methods of Dealing with Externalities
1. Direct Regulation
- A program of direct regulation is where the amount of a good people are allowed to use is
directly limited by the government.
- Economists do not like this solution since it does not achieve the desired end as efficiently
(at the lowest cost possible in total resources without consideration as to who pays those
costs) and fairly as possible.
- Direct regulation is inefficient because it achieves a goal in a costlier manner than
necessary.

2. Incentive Policies
- Incentive programs are more efficient than direct regulatory policies.
- The two types of incentive policies are either taxes or market incentives.

Tax Incentive Policies

à A tax incentive program uses a tax to
create incentives for individuals to structure
their activities in a way that is consistent
with the desired ends.
à Often the tax yields the desired end more
efficiently than straight regulation.
à This solution embodies a measure of
fairness about it – the person who
conserves the most pays the least tax.
à Another way to handle a negative
externality is through a pollution tax or effluent fees.
à Effluent fees – charges imposed by government on the level of pollution created.

Market Incentive Policies

à An alternative to direct regulation is some type of market incentive program.
à Market incentive program is a plan requiring market participants to certify total
consumption – their own or other’s – has been reduced by a specified amount.
à A market incentive program is similar to the regulatory solution in that the amount of the
good used is reduced.
à A market incentive program differs from a regulatory solution in that individuals who
reduce consumption by more than the required amount are given a marketable
certificate that can be sold to someone else.

3. Voluntary Reductions
- Voluntary reductions leave individuals free to choose whether to follow what is socially
optimal or what is privately optimal.
- Economists are dubious of voluntary solutions.
- A person’s social conscience and willingness to do things for the good of society generally
depend on his or her belief that others will also be helping.
- If a socially conscious person comes to believe a large number of other people will not
contribute, he or she will often lose their social conscience.
à This is another example of a free rider problem – individuals’ unwillingness to share in the
cost of a public good.

Optimal Policy
• An optimal policy is one in which the marginal cost of undertaking the policy equals the
marginal benefit of that policy.
• Should pollution be totally eliminated?
 à Some environmentalists say “yes.”
à Economists would answer that doing so is costly so marginal costs should be balanced against
marginal benefits.
à The point where MC = MR is called the optimal level of pollution.
à Optimal level of pollution – the amount of pollution at which the marginal benefit of reducing
pollution equals the marginal cost.

Public Goods
• A public good is one that is nonexclusive (no
one can be excluded from its benefits) and
nonrival consumption by one does not
preclude consumption by others.
• There are no pure examples of a public
good – closest example is national defense.
• Technology can change the public nature
of goods – Roads are an example.
• Once a pure public good is supplied to one
individual, it is simultaneously supplied to all.
à A private good is only supplied to the
individual who bought it.
• With public goods, the focus is on groups.
à With private goods, the focus is on the individual.
• In the case of a public good, the social benefit of a public good is the sum of the individual
benefits.
• Adding demand curves vertically is easy to do in textbooks, but not in practice. This is because
individuals do not buy public goods directly so that their demand is not revealed in their actions.

Informational Problems
• Perfectly competitive markets assume perfect information.
• Real-world markets often involve deception, cheating, and inaccurate information.
• When there is a lack of information, buyers and sellers do not have equal information, markets
may not work properly.
• Economists call such market failures adverse selection problems.
- Adverse selection problems – problems that occur when a buyer or a seller have different
amounts of information about the good for sale.

Policies to Deal with Informational Problems

1. One policy alternative to deal with information market failures is to regulate the market and see
that individuals provide the correct information.
2. Another alternative is for the government to license individuals in the market and require them
to provide full information about the good being sold.
à Regulatory solutions may be overly slow or costly.

Market in Information
• A market in information is one solution to the information problem.
• Information is valuable and is an economic product in its own right.
• Left on their own, markets will develop to provide information that people need and are willing
to pay for it.
• Economists who do not like government interference point out that informational problems are
not a problem of the market; it is a problem of government regulation.

Licensing of Doctors
à Licensing of doctors is a debate that is motivated by information problems.
 à Currently all doctors practicing medicine are required to be licensed – this was not always
so.
à Licensing of doctors is justified by informational problems. Some economists argue that
licensing is as much a problem of restricting supply as it is to help the consumer.
à Why, if licensed medical training is so great, do we even need formal restrictions to keep
other types of medicine from being practiced? Whom do these restrictions benefit: the
general public or the doctors who practice mainstream medicine? What have the long-term
effects of licensure been?

Informational Alternative to Licensure

à As an alternative, the government could provide the public with information about which
treatments work and which do not.
à This would give rise to consumer sovereignty – the right of the individual to make choices
about what is consumed and produced.
à In this scenario, the government would provide such information as: Grades in college,
Grades in medical school, Success rate for various procedures, References, Medical
philosophy, Charges and fees.
à This information alternative would provide much more useful information to the public than
the present licensing procedure.
à Some words of caution about the informational alternative:
à To get a true picture of whether the present system is best would require experts on real-
life practices and institutions.
à The problem is that the experts may have a vested interest in keeping things just the way
they are.

Government Failures and Market Failures

• Market failures should not automatically call for government intervention because governments
fail too.
• Government failure occurs when the government intervention in the market to improve the
market failure actually makes the situation worse.

Reasons for Government Failure

1. Governments do not have an incentive to correct the problem.
2. Governments do not have the information to deal with the problem.
3. Intervention in the markets is almost always more complicated than it initially looks.
4. Government intervention does not allow fine-tuning, and so, when the problems change, the
government solution often responds far more slowly.
à Government intervention leads to more government intervention.

Theory of Economic Growth

• Traditionally labor and capital were introduced as the only variables determining the level and
the growth of output. Y = f (K,L).
• Land was assumed to be included within capital.
• Other factors were not considered until it was noted by Solow that there was a large residual
factor that was unexplained.
• Substantial time has been spent explaining this residual.
• This residual has been called total factor productivity (TFP) or sometimes multifactor productivity.
• TFP is very large in industrial countries, explaining as much or more than 50 percent of economic
growth in the postwar era.

Total Factor Productivity

• Y = f (K,L,A).
• What factors are included in the residual (A)?
 a. the adoption of new technology,
b. better educated workers,
c. better management,
d. better coordination within the organization,
e. more efficient production techniques,
f. better inventory management,
g. better and cheaper distribution and marketing skills and organization.

Testing Different Growth Theories

• Many different approaches have been devised to test these alternatives. In doing this, it is useful
to distinguish between embodied and disembodied technical progress (TFP).
• Embodied TFP can be measured by adjusting the factor inputs of labor and capital.
Disembodied TFP cannot – it has to go into the residual.

Growth Theories
1. Harrod-Domar Model
- Dynamic version of a simple Keynesian model.
- Growth is dependent on the rate of capital formation and the efficiency of the use of capital
(capital/output ratio).
- Population growth can be added and it reduces the rate of growth ceteris paribus.

s
g* = -h - d
q
2. Solow Model
- It introduces diminishing returns to capital and focuses on the long run.
- Convergence to a steady state level of per capita income occurs despite differences in initial
conditions.
- Total income grows at the same rate as population.
- The higher the rate of saving, the higher the steady state level of per capita income.
- When we add technical progress to the Solow model in the form of more efficient workers,
then we have growth in per capita income at the same rate as the rate of growth in worker
efficiency.
à There is still a steady state but it now relates to efficiency units of capital.

3. Power Balance Theory

- Emphasized exploitation of poor “southern” economies by the rich industrial “northern”
economies.
- Deterioration of terms of trade of agricultural products in poor economies further aggravates
the situation.
- The theory has generally been discredited.

4. Structuralist Approach
- The structural approach was developed in the 1960s and 1970s by Hollis Chenery. Chenery
was initially trained as an engineer and this approach reflects his training.
- Structural approaches stress the shift in output among the sectors of the economy and the
rigidities that hinder them.
- A shifting balance between the three major sectors of the economy – agriculture, industry
and services.
- Agriculture diminishes over time and industry increases. Productivity is higher in industry so
higher growth depends upon this shift.
- A stereotypical pattern of economic growth which has been observed in many countries.
 à Initially, agriculture has a large share of output when the economy is at a low level of
development. Share of industry and services are small.
à As industrialization takes place, the share of agriculture declines and that of industry and
services grow.

5. Two-Sector Model of Growth

- The Lewis-Fei-Ranis model (LFR), named after the three economists that developed it, is a
two-sector model – a modern and a traditional sector.
- Resources move from the traditional to the modern sector and this spurs growth.
- The beauty of the LFR model is that it describes many of the characteristics of the Asian
economies when they were just beginning on the path to rapid development in the 1960s
and 1970s. That is why it has become so popular among development economists studying
Asia.

6. Solow Growth Model

(1+ h) k (t+1) = (1- d) k (t) + s y (t)
à where k and y denote the per capita units of capital and output, respectively, i.e. k(t)=
K(t)/P(t) and y(t)=Y(t)/P(t).
- This fundamental Solow equation says that the amount of per capita capital in the current
period depends upon the per capita capital in the last period, the saving rate in the previous
period and the rate of population growth.
- From the foregoing, it follows that as the economy moves to a steady state level of per
capita capital stock regardless of initial conditions.
- In the steady state, there is no deepening of capital and the amount of capital per capita
remains unchanged from period to period as does the level of per capita income. That is,
there is no long run growth in per capita income.
- Total income growth rate h is thus assumed to be the same as the rate of growth for
population.
- Further, in the Solow model framework, the savings rate has no effect on the long run growth
rate of per capita output which is zero.
- However, the saving rate does affect the equilibrium level of per capita income.
- The higher the saving rate, the higher the steady state level of per capita income.

7. New Growth Theory

- New growth theories that go beyond Solow have been developed in the past decade.
- They stress the importance of externalities and the possibility of increasing returns to scale
rather than the decreasing returns to scale of the Solow model.
- The key to this is human capital formation.
- Higher per capita incomes tend to slow growth because of diminishing returns but higher
endowments of human capital tend to speed up growth.
- Returns to such investments may be increasing.

Asian Growth Miracle

• Although individual experiences vary, South Asia did not generally begin to grow more rapidly
until the late 1980s and early 1990s, when government policy shifted toward supporting a more
open and competitive environment.

Policy Environment Before the Transition to Rapid Growth

• The policy environment in most developing countries throughout the world stressed import
substitution policies for industry.
• The theory was that developing countries had a comparative advantage in primary products
and so they should export these products.
 • The import substitution theory also argued that since incomes were low, savings rates were also
low. Inflows of investment and financial aid were needed to lift growth.
• To minimize on foreign exchange outflows, industries that substituted for some imports were
promoted by government policy.
• Such a strategy, which was followed for several decades after World War II in many developing
countries, simply perpetuated the cycle of North-South trade and reinforced protectionist
policies that contributed to a lack of competition and economic inefficiency.
• What Japan and later the countries of East Asia did was to begin to develop an environment
that stressed outward looking trade policies and the acquisition of foreign technology.
à In the case of Japan, many believe it was an attempt to develop a mercantilist strategy to
help it recover its influence after the defeat in World War II.

Primary Factors of the Asian Growth Miracle

1. Openness
- The first factor in the primary strategy was outward looking
policies and emphasis on exports and acquisition of foreign
technology.
- First, some industrial capability was built up by focusing on
import substitution in industries with ties to agriculture –
footwear, food processing and textiles.
- Second, after some years, industrial policy shifted to
promoting external markets.
à Initially, this focused on extending the scope of the
industries that were producing for the domestic markets
such as textiles and apparel, leather products and footwear
and food processing.
- In Southeast Asia, the focus was also put on rubber, sugar,
coconut and palm oil products as well as some specialized
textile products such as silk.
- Slowly the emphasis shifted toward labor intensive
industries that were not necessarily tied to the agricultural
base such as electronics assembly and apparel.
- The shift from import substitution to export promotion was
led by a shift in the trade regime so that there were lower
tariff rates on exports and imports (see Table 2.3).
- Non-tariff barriers, including bureaucratic procedures and
graft/corruption as well as import bans on some items, were
also reduced.
- Transformation to labor intensive export oriented industry
was supported by flow of foreign direct investment – initially
from Japan and the US, particularly in Korea, Taiwan and
the Philippines.
à Later the volume increased and more flows began
coming in from Europe.
- A virtuous cycle of growth was created by this shift in
emphasis from import substitution to export promotion (see
Tables 2.4 and 2.5).
- In South Asia, on the other hand, the shift occurred much
more slowly.
- Technological transfer served to reinforce the shift in export
emphasis.
- Foreign technology acquired by buying from foreign
companies under license.
 à By copying it without license – sometimes legally and sometimes not.
à By entering into joint ventures (FDI).
à East Asia (Korea, Japan, Taiwan) by and large followed the first route while Southeast Asia
followed the second.
- The flow of FDI increased following the Plaza accord in 1985 when the yen appreciated and
Japan began to move some of its labor intensive industries offshore.

2. Macroeconomic Stability
- The second set of primary factors focused on the importance of macroeconomic policies
and the role of the government.
- Governments generally followed polices that created and supported a competitive
environment for export-oriented industries but not necessarily for the domestic market.
Japan is a good example of the latter.
- The amount of government intervention didn’t seem to have a direct effect on performance.
- There was a lot of government intervention in the industrial and financial sectors in some
countries and little in others.
à In Korea, Japan and Singapore, there was a lot while there was less in Malaysia and
Taiwan.
à In Hong Kong and Thailand, on the other hand, there was virtually no intervention.
- What was important was the efficiency and incorruptibility of the bureaucracy.
à In the Philippines and Sri Lanka, policy environments were similar to those in the successful
countries but growth was slowed by other factors such as corruption, lack of political will,
corruption and domestic unrest.
- The efficiency of government as well as policies followed were important. Taiwan and
Singapore are good examples.
- Efficient governments are characterized by little rent seeking, salaries are competitive and
promotions are based on performance not on seniority, patronage or crony connections.
- Some policies such as financial repression and directed government lending programs were
wasteful.
- But the flow of resources for investment were substantial and the wastefulness and distortions
created by these policies didn’t surface until the 1990s bubble broke.

3. Education Policies
- The third set of primary factors focused on education policies.
- As stressed by the new growth theories, education played a
critical role in both the transition to an export led growth strategy
and to the ability to sustain it (see Tables 2.8 and 2.9).
- By 2000, some of the educational advantages of Asia had began
to erode.
- There were two reasons for this:
a. diminishing returns since more resources had to be devoted
to secondary and tertiary education.
b. rapid rate of income growth that tended to outstrip the
corresponding growth in human development.
- Behrman and Schneider conclude that schooling attainment in
miracle economies was not particularly outstanding.

4. Labor Market Flexibility

- The conclusion is that labor market flexibility has to be
considered along with education.
- The miracles economies did not have strong unions until recently
(Korea) and weak minimum wage legislation.
 - ILO rates the miracle economies as among those with the most flexible labor markets.
- Mobility from rural to urban is also high.

Secondary Factors of the Asian Growth Miracle

1. Differences in Initial Conditions
- Initial conditions played a part in the success of the miracle conditions.
- Land, income and wealth distribution in the miracle economies were generally more even
than in other countries and regions.
- Average educational attainment was high at the beginning of the high growth period.

2. Sector Policy
- Sector policies were influential to the growth of the miracle economies.
- Agricultural sector policies were not particularly onerous. There were taxes on agriculture,
but sector was still viable.
- Industrial policies were benign, and competition flourished in most countries.
- In Korea and Taiwan, “infant industry” protection policies were strictly enforced and favored
export industries were monitored for efficiency and export performance. Subsidies were
withdrawn if performance was below expectations.
à There is considerable debate about whether industrial policy in these two countries was
beneficial or not.
à Whatever the outcome of these discussions, it is a fact that growth was rapid in both
countries.

Aspects of Economic Performance

• High levels and growth rates of savings and investment in miracle economies.
à Both of these variables increased dramatically as a percent of income (see Tables 2.6 and
2.10).
• Furthermore, the saving-investment gap was small or even negative for some countries (see
Table 2.11).
• Increased productivity in miracle economies.
• Measures of TFP show a modest contribution to output growth until the middle of the 1980 and
an acceleration afterwards.
à The latter is the combined result of previous transfer of technology and more rapid FDI
following the Plaza accord.

Convergence of Income
• The Solow model tells us that incomes will converge to a steady state irrespective of where they
started out. This assumes that the technical progress coefficient, p, remains constant across all
countries. Is this a realistic inference?
 à To test this hypothesis of absolute convergence, we can see if there is a relationship between
per capita income in an initial period and the growth in income in successive periods. Using
logs to denote growth we have, for the period 1960 to 1990,
log[Y (1990) - Y (1960)] = a + b log Y (1960)
• Tests of this model for several sets of countries shows that it doesn’t hold for a heterogeneous
group of countries around the world.
à It does hold for OECD countries and for OECD and Asian countries together.
à It does not hold for developing countries in general.
• A less restrictive form of convergence is called conditional convergence.
à In this form of the model, we allow the various parameters of the growth equations to change
between different countries or groups of countries
à There would still be a convergence in growth rates of income but the level of income in the
steady state would differ.
à This level would depend upon saving rates, population growth rates and depreciation rates
of capital.
• Tests of this model show that there is still a lot of unexplained variation in per capita income,
although variations in population growth rates and saving rates did explain about half of the
variation in per capita income across countries.
à However, these results imply that the rate of convergence is very slow.
à What is likely is that a number of other factors are involved aside from the saving and
population growth rates, such as the spread of technology and the role of education.

Convergence
• There is evidence that there is convergence within groups of countries with similar geographic
and economic similarities such as the European Union or countries in East Asia.
• However, there is less evidence that there is convergence between rich and poor countries
• For example, globally there is strong evidence for divergence.
• Rich countries get richer and poor countries get poorer.
• This does not hold within countries although the convergence is slow.
• German states and Japanese prefectures and states of the US are converging.

Summary
• Review of the various economic growth theories.
• Application of the growth theories to the Asian growth miracle.
• The importance of primary and secondary factors in the success of the Asian miracle
economies.

Asian Crisis and Recent Developments

Start of Asian Crisis
• June 1997, after a sustained attack on the
currency led by currency hedge funds, the
Thai baht sustained a large devaluation.
• Currency devaluations in Malaysia,
Indonesia and the Philippines followed in
July.
• The currency weakness extended to
Australia, Hong Kong and Korea currencies
in October.

The Asian Crisis

• By early 1998, currencies fell by 35% to 55%
for Korea, Philippines, Malaysia and
 Thailand, and more than 15% for Singapore and Taiwan.
• Indonesia suffered greatest fall of 80%.
• Equity prices also fell as a result of investor uncertainty and currency volatility (Table 3.1).
• Thin and restricted equity markets exaggerated the decline.
• Lack of hedging facilities forced investors to reduce holdings dramatically.
• Interest rates were raised to help stabilize currencies and liquidity was reduced.
• The result was a sharp decline in aggregate economic activity in late 1997 and in 1998.

Explanations for the Asian Crisis

• There are three broad explanations, none of them completely satisfactory.
1. Speculative Bubble/Bubble Economy
- First, a speculative bubble in the housing and equity markets arose which was funded and
sustained by excessive lending by the banking system.
- The bubble economy was the result of interaction between lenders (mostly banks) that
borrowed offshore at high interest rates and relend at higher rates to domestic investors.
- The domestic investors borrowed extensively to finance speculative investments in the
housing and equity markets.
- This created a speculative bubble that depended on a stable exchange rate and high
profits.
- High profits became more improbable as the boom reached its peak, which was further
undermined by the successive devaluations in all the economies as the crisis unfolded.
- Banking weakness was reinforced by a lack of competition and unsound lending practices.
- These included risky long-term lending in local currency using short term dollar loans from
overseas lenders.
- When these borrowers defaulted it resulted in the inability of the banks to repay these short-
term dollar obligations.
- This banking crisis was also influenced by moral hazard.
- Moral hazard occurs when an agent takes more risk because they are insured against the
negative consequence of such actions.
à In the case of the Asian financial crisis banks thoughts that governments would insure a
stable exchange rate.
à They also might have thought that the government would bail them out if they found
themselves in financial trouble

2. External Sector Difficulties

- Second, external sector difficulties emerged including slow export growth, loss of external
competitiveness and rapid growth in current account deficits.
- As the bubble of the early 1990s progressed, current account deficits also grew as offshore
borrowing increased.
- While exports were growing rapidly, this was viewed as a sign of strong investment and
growth enhancing capital expansion.
- However, when export growth began to sag in 1996 this large current account deficits
became a growing liability and worry for international investors.
- Exchange rates were tied to the dollar and exports were hurt in international markets as the
dollar appreciated in the mid 1990s

3. Contagion Mechanism
- Third, capital flight and investor panic spread across the region through a contagion
mechanism as a result of globalization.
- There was a strong contagion effect as the financial crisis spread across the region.
- Countries that had strong currencies and economies, such as Hong Kong, Singapore and
Taiwan were also adversely affected.
 - As the foreign exchange crisis unfolded, there was a dramatic turnaround in net private
capital flows to the region – from a $97 billion inflow in 1996 to a $12 billion outflow in 1997.
- This $109 billion reversal was about 10% of the GDP of the five most affected economies –
Indonesia, Korea, Malaysia, Philippines, and Thailand.
- There was also a dramatic reversal in bank credit which also amounted to about 10 percent
of GDP.
- Together, the reversal of capital flows and bank credit created a liquidity crisis that led to a
sharp fall in income and output.
- Indonesia, which had been a model of probity and sensible policies was hardest hit by the
crisis as its exchange rate fell by over 50 percent and aggregate incomes fell dramatically.
- This contagion effect was the result of investors pulling out of many economies
simultaneously.
- The pressure that arose on all the currencies of the region could have been a combination
of this contagion effect as well as a process of “competitive devaluations” as investment
funds left the region.

Post-Crisis Experience
• The impact of the crisis was fully felt in 1998 when all the crisis countries and most other countries
had negative or very small rates of positive growth.
• PRC and Taiwan were the only exceptions.
• Equity prices also fell across the region in 1998.
• Beginning in 1999, there has been a recovery in growth and equity markets.
• This recovery has been accompanied by a significant amount of industrial and financial
restructuring.
• Many countries suffered from a high level of Non-Performing Loans (NPLs).
• à To deal with these NPLs, the most affected countries created separate agencies to deal with
them. These Asset Management Companies (AMCs) have taken many of the bad loans and
negotiated their liquidation.
à Korea and Malaysia have been particularly successful in reducing NPLs, enabling the
banking system to begin to extend new loans.
à Thailand and Indonesia have been only moderately successful while in the Philippines, the
level of NPLs, though small during the crisis, has crept up in recent years.

Social Impact of the Crisis

• The fall in output and employment created hardships for many segments of the society in the
affected countries.
• There was significant reverse migration to rural from urban areas as job opportunities dried up.
• Poverty levels increased between 1997 and 1998.
• Disadvantaged groups such as the poor, women, children and the elderly were the worse hit by
the crisis.
• Some adverse effects on school enrollment and on health indicators were observed.

The Recovery: Part 1

The Recovery: Part 2
• Between 2002 and 2007 economic growth in the Asian region accelerated, led by India and
China. Living standards increased and poverty fell.
• Domestic demand and foreign trade were both important factors in the resumption of growth.
• As the recovery progressed, financial restructuring proceeded and the financial systems
strengthened.

2005 2006 2007

Thailand 4.5 5.1 4.8
Malaysia 5.3 5.8 6.3
Indonesia 5.7 5.5 6.3
Philippines 5.0 5.4 7.2
Hong Kong 7.1 7.0 6.4
Singapore 7.3 8.2 7.7
Korea 4.2 5.1 5.0
Taiwan 4.2 4.9 5.7
China 10.4 11.7 11.9

• The region has grown much richer in the decade since the Asian crisis.
• China has emerged as a regional economic powerhouse.
à Half the GDP of the region and one third of exports originates in China
à China is now the largest trader in Asia overtaking Japan.
à China joined WTO several years ago.
à Import GDP ratio is 34% in China versus 9% for Japan.
• Shows Japan is still somewhat protectionist.
• Middle income countries are being squeezed by China. In Southeast Asia in particular.
• China competes in many different international markets from labor intensive to skill intensive.
• Innovation and new products are drivers of trade in Asia now.
• 60% of export growth in Asia is in new varieties and products not more of the same products.
• Geography and outsourcing are important and locational advantages are shaped by various
factors.
• History, availability of manpower, availability of capital, cost of shipping and agglomeration
economies all play a role.
à Shenzhen in China and Bangalore in India are examples of agglomeration economies.
• Export processing zones help create incentives for high growth export development and
innovation.

The Recovery: Part 3

• As the global economic crisis unfolds in 2009 Asia is being adversely affected.
• Slower growth in Asia in 2009 and perhaps 2010 is anticipated.
• There will be a slowdown in export demand from Europe, Japan and the United States.
• Asia is in good shape to offset these anticipated weaknesses in the foreign sector with monetary
and fiscal stimulus.
• Most countries cut interest rates in last four months of 2008.
• Falling energy and food prices should ameliorate any tendencies toward inflation.
• There has been general fiscal stimulus.
• China’s projected $850 billion additional spending on infrastructure in next few years.
• East Asia and Southeast Asia have current account surpluses.
• All countries in the region have ample foreign exchange reserves.
• India could have a more difficult time than the rest of the region.
à It has a large fiscal deficit which limits fiscal stimulus.
• Lack of willingness of overseas lenders to investment.
 • As the global recession deepens greater cuts in employment and exports in Asia.
• Could create greater social tension.
• Exacerbate poverty with reverse migration.
• Singapore, Hong Kong and Malaysia most exposed to foreign trade.
• Both Hong Kong and Singapore adversely affected in Asian crisis of 1997.
• Thailand’s prospects will also be adversely affected by political uncertainty.
• Taiwan will have to fight its way through a recession that has already begun.
• Korea has a lot of household debt which could slow the economy further.
• But a big fiscal stimulus and currency depreciation of around 30 percent in 2008 which should
boost exports.
• Volatility in many markets will restrain risk taking and investment.
à Volatility causes sharp changes in balance of payments
• Puts pressure on governments to adjust their budgets to reflect these shifts.
• It creates uncertainty in the business community
• Has a dampening impact on investment.
• The economic recovery continued into the second and third quarter of 2009.
• Industrial countries and developing countries in Asia all benefited.
• Stimulus packages were adopted by many countries including fiscal and monetary measures.

Country Fiscal stimulus 2009/2010 as a percent of GDP

China 4.8
India 0.5
Indonesia 2.5
Korea 2.7
Malaysia 5,5
Philippines 4.1

Agenda for Reform

• In the wake of the Asian crisis, there were a number of reforms
• Continuation of the debt restructuring process with help of AMCs.
• Arrangements of credit lines with the private sector.
• Reform of exchange rate regimes to reduce the chance of abrupt currency devaluation.
• The movement of hot money that takes advantage of large short-term interest differentials was
discouraged or made illegal.
• Consideration of capital account reforms to include possible taxes on short-term capital but
were not approved.
• Possible controls on international portfolio movements were also considered but not
implemented.
• Minimum international standards of financial practice were implemented.
• Accountability and transparency of business practices strengthened.
• Increased international surveillance to detect possible future financial crises have been
considered but not implemented.
• Basle accords used to strengthen supervision and regulation of banking systems.
• Introduce greater competition in financial markets while strengthening prudential regulations.
• Improve accounting and disclosure standards.
• Introduce greater flexibility and depth into financial markets including greater hedging and
providing greater access for foreign investors.
• Maintain open trading environments in keeping with WTO and regional trading arrangements.
• Look into ways of restraining FDI concessions that distort incentives and distort the flow of
investment.
• Enhance the flow of technical expertise, innovation and human capital flows and exchanges.
• Continue to undertake research into the process of financial and economic crises.
Growth Projections
y = (ls) h + (1- ls) k + a
• Where y is growth income, h is the rate of change in education adjusted labor input, k is the
rate of growth in capital, ls is labors share in income, (1- ls ) is capital’s share in income and a is
total factor productivity.
• If we assume that the capital to output ratio is fixed in the short-run then we can substitute y for
k on the right hand side of this equation and rearrange
y = h + a/ ls
• Income growth (y) is a function of the growth of the labor force adjusted for improved quality
by higher education and better health (h), the share of labor in total income (ls) and TFP (a).
• The rest of the section looks at various assumptions about these factors and projects growth into
the future.
• The main conclusion is that estimates for TFP (a) in South Asia using the past tend to
underestimate the rate of growth.
• We have also oversimplified because we haven’t looked at saving potential.
• By considering the factors in these simple growth models we can get some insights into what
causes rapid growth:
a. Investment
b. TFP (a)
c. Labor force growth (ls)
d. Education and health (h)
e. Governance, corruption, foreign investment also important as indirect determinants of TFP

Summary
• Causes of the Asian financial crisis.
• Analysis of the impact and severity of the financial crisis in affected countries.
• Policy implications gained.