Classic Theories of Economic

Growth and Development (II)

Todaro & Smith (2015), Economic Development - Chapter 3

Lucia Piscitello, 9th March, 2021

 Classic Theories of Economic
Development: Four Approaches

1. Linear stages of growth model

2. Theories and Patterns of structural change

3. International-dependence revolution

4. Neoclassical, free market counterrevolution

 2. Structural-Change Models

• Focus on mechanisms by which underdeveloped

economies transform their domestic economic
structures (from traditional subsistence agriculture
to a more modern, urbanized, and industrially
diversified economy)

• Tools employed: neoclassical price and resource

allocation theory; modern econometrics to describe
how the transformation process takes place
 Structural-Change Models

• Two well known representative examples of

this approach are:

1. The «two-sector surplus labor» theoretical

model of W. Arthur Lewis (1954)

2. The «patterns of development» empirical

analysis of Hollis B Chenery and his co-
authors (1975)
 The Lewis theory of economic
development – Nobel 1979
- General theory of the development process in
surplus-labor developing nations during most of
‘60s and early ‘70s (still sometimes applied, e.g.
recent growth experience in China)

- The economy consists of two sectors:

1. Traditional, overpopulated, rural subsistence sector,

characterized by zero marginal labor productivity
(surplus labor, which can be drawn from the agricultural
sector without any loss of output)
2. High-productivity modern industrial sector in which labor
from the traditional sector is gradually transferred
 Key question: how agriculture can help industrial growth,
inducing structural change in the economy

1. Fundamental asymmetry between the two sectors (dualism):

– Agriculture uses land and labour in production
– Industry uses capital and labour
– Capital accumulation only happens in industry
– The two sectors are related through the labor market

2. In industry employers must attract workers by offering them

their opportunity cost in agriculture plus their migration cost

3. Agriculture can contribute to industrial growth through 2 effects:

1. It can release labor for industrial employment

2. It can lower the price of food to lower the nominal wage and the cost of
labor for industry, thus favoring employment in industry
 Major focus on:

1. The process of labor transfer from the traditional to the

modern sector

2. The growth of output and employment in the modern sector

NB. Both are brought about by output expansion in the modern

sector
 Major focus on:
1. The speed with the expansion in the modern sector occurs is
determined by the rate of industrial investment and capital
accumulation in the modern sector
2. Such investment is made possible by the excess of modern
sector profits over wages on the assumption that capitalists
will reinvest all their profits.
3. The level of wages in the urban industrial sector is assumed
constant (determined as a given premium over a fixed
average subsistence level of wages in the traditional
agricultural sector)
4. At a constant urban wage, the supply curve of rural labor to
the modern economy is considered to be perfectly elastic
Figure:
The Lewis Model of
Modern-Sector Growth in
a Two-Sector Surplus-
Labor Economy
 Self-sustaining growth
• This process will continue until all surplus rural labor is
absorbed in the new industrial sector

• Thereafter, additional workers can be withdrawn from the

agricultural sector only at a higher cost of lost food
production because the declining labor to land ratio means
that the marginal product of rural labor is no longer zero
(Lewis turning point)
 Criticisms of the Lewis Model
Four of its key assumptions do not fit the institutional and
economic realities of most contemporary developing countries

1. Rate of labor transfer and employment creation may not be

proportional to rate of modern-sector capital accumulation

2. Surplus labor in rural areas and full employment in urban?

3. Institutional factors?

4. Diminishing returns in modern industrial sector

Figure 3.2 The Lewis Model Modified by Labor
saving Capital Accumulation: Employment
Implications
Empirical Patterns of Development
 Empirical Patterns of Development

- Role of domestic and international constraints

- Common features of developed countries’ development

pattern:
• Switch from agriculture to industry (and services)
• Rural-urban migration and urbanization
• Steady accumulation of physical and human capital
• Population growth first increasing and then decreasing with
decline in family size
 Empirical Patterns of Development

-
 Empirical Patterns of Development

• From the middle of the

nineteenth century
onwards, the world
economy had divided into
industrial economies and
agricultural economies.

• Colonies and non-

colonised countries in the
tropics remained
predominantly agrarian,
while the Western world
and the Asian latecomer
Japan industrialised.
 Structural change and the emergence of manufacturing

Notes:
• In the ISIC
classifications, the
industrial sector (IND)
includes not only
manufacturing (MAN)
but also mining,
construction and
utilities.
• Long-run contraction in
the shares of
manufacturing in the
advanced economies,
while there was a
modest long-term
increase in the shares of
manufacturing in
developing countries,
especially till around
1980.
• By 2005, the average
share of manufacturing
in the developing world
is similar to that in the
advanced economies.
Why is manufacturing considered to be an engine for growth?

1. Empirical correlation
between the degree of
industrialisation and per
capita income in
developing countries.

• Major exceptions among

the advanced economies
are primary exporters
(e.g. Norway, Canada
and Australia).

• Among the developing

countries, Taiwan,
Thailand and Brazil rank
higher in terms of
industrialisation than in
terms of income.

• Nevertheless, the table

illustrates the general
point about
industrialisation.
 Why is manufacturing considered to be an engine for growth?
2. Labour productivity in
agriculture is much lower than
labour productivity in industry.

• Value added per worker is

much higher in manufacturing
than in agriculture.
• not surprising that labour
productivity in the capital
intensive mining sector is far
higher than that in
manufacturing.
• Results with regard to services
are more puzzling. Between
1950 and 1970, labour
productivity in the service
sector in Latin American
countries is much higher than
in manufacturing.
• If this is not due to measure-
ment error, this would suggest
that transfer of resources to
services would provide a
higher static shift effect than in
manufacturing, which is
counterintuitive.
• From 1980 onwards, more in
line with our expectations
 Classic Theories of Economic
Development: Four Approaches

1. Linear stages of growth model

2. Theories and Patterns of structural change

3. International-dependence revolution

4. Neoclassical, free market counterrevolution

3. The International-Dependence Revolution
• The neocolonial dependence model

– Unlike the Stage Theories or the Structural Change Models of economic

development, which considered underdevelopment as a result of
internal constraints (such as insufficient savings, investment or lack of
infrastructure, skill or education), the proponents of the Neocolonial
Dependence model portray third world underdevelopment as an
externally induced phenomenon.

– is basically a Marxist approach. Underdevelopment is due to the

historical evolution of a highly unequal international capitalist system of
rich country-poor country relationships.

– Legacy of colonialism, Unequal power, Core-periphery

The International-Dependence Revolution

• The false-paradigm model

– Underdevelopment is due to faulty and inappropriate advice provided by

often uninformed, biased, and ethnocentric international (often
Western) expert advisers to developing countries.
– Elegant but inapplicable theoretical models
– IMF and World Banks took a lot of blame from the advocators of this
model. Joseph Stiglitz in Globalization and its discontents (2002) and
Making Globalization Works (2007) and Jeffrey Sachs in The End of
Poverty (2005) documented some cases where inappropriate advices
were given by expert advisers from developed countries to developing
nations.
The International-Dependence Revolution
• The dualistic-development thesis

– This thesis recognizes the existence and persistence of increasing

divergences between rich and poor nations, and between rich and poor
people at various levels. The urban elites in developing countries will
remain rich and become richer. The wealth of these elite will not trickle
down to the rest of the society.

– According to the World Bank, the average for the richest twenty
countries in the world was 15 times the average for the poorest twenty
countries in 1960, and in 2000 it is 30 times — twice as high.

– However, case studies of Taiwan, South Korea, China, Costa Rica, Sri
Lanka, and Hong Kong demonstrated that higher income levels can be
accompanied by falling and not rising inequality. The inverted Kuznets
Curve shows that as income per capita continues to increase inequality
of income can be reduced.
The International-Dependence Revolution

• The inverted Kuznets Curve (Kuznets, 1955) - The relationship

between income inequality and economic development

Gini
coefficient

income

Income inequality tends to increase at an initial stage of development and then

decrease as the economy develops, implying that income inequality will fall as
income continues to rise in developing countries (however, when income has
kept rising and reached a high level, income inequality increases again).
The International-Dependence Revolution

• Criticisms and limitations

– Does little to show how to achieve development in a positive sense;
accumulating counterexamples

– Dependency theories offer little explanation for economic growth and

sustainable development. They tell us little on how to obtain economic
growth.

– The actual economic experience of developing countries that pursued

nationalization and introduced state-run production had been mostly
negative. Nationalized companies were usually badly managed.
Consequently, the operations were inefficient and productivity fell.
Falling output led to falling export earnings. This was bad news for
growth.
 Classic Theories of Economic
Development: Four Approaches

1. Linear stages of growth model

2. Theories and Patterns of structural change

3. International-dependence revolution

4. Neoclassical, free market counterrevolution

4. The Neoclassical Counterrevolution: Market
Fundamentalism (‘80s and early ‘90s)

• Challenging the Statist (Marxist) Model:

– Free market approach: permitting free markets to flourish, privatizing

state-owned enterprises (SOEs), promoting free trade and exports,
welcoming investors from developed countries, and eliminating
government regulations, both economic efficiency and economic growth
will be stimulated.
– Public choice approach: politicians, burocrats and states act solely from a
self-interested perspective: minimal government is the best government,
as governments can do nothing right.
– Market-friendly approach: governments have a key role to play in
facilitating the operation of markets through non selective (market
friendly) interventions, e.g. investing in physical and social infrastructures,
health care, educations to solve market failures.
The Neoclassical Counterrevolution: Market
Fundamentalism (‘80s and early ‘90s)

• Main Arguments
– Denies efficiency of intervention
– Points up state owned enterprise failures
– Stresses government failures

– Reaganism (free-market approach): economic policies promoted by U.S.

President Ronald Reagan during the 1980s
– Thatcherism’s variant of contemporary free-market neoliberalism in the
UK during the 1980s

– Traditional neoclassical growth theory - with diminishing returns, cannot

sustain growth by capital accumulation alone [Robert Solow (1956)]
– Growth due to increased capital stock as in Harrod-Domar Model can only
be temporary because capital is subjected to diminishing marginal returns.
– The economy can achieve a higher long-run growth path only with a
growth in labor supply, labor productivity or capital productivity.
– Variation in growth rate is explained by difference in the rate of
technological change which affects labor and capital productivity.
– Advances in technology however is independent of the rate of investment,
that is technology is exogenous to the model.
 Take-home messages

1. Structural change models try to answer the how and why

development does or does not take place: role of
industrialization

2. Development = economic growth

3. Importance of empirical evidence (large databases)

4. Role of internal endowments/investments vs. external relations

5. Need to relax some of the stringent hypotheses (i.e. constant

productivity)