DEVELOPMENT POLICY

ANALYSIS
Zerihun Berhane (PhD), CAfOS,
Addis Ababa University
zerihunbw@yahoo.com
WHAT IS THE COURSE ALL ABOUT?

29-Sep-20
 This course introduces you with the theoretical
concepts & frameworks useful for scanning the
environment within which policies operate & guide the
formulation, implementation & evaluation

 Review policy analysis methods, preparation of a

policy document, method to review a policy document,
& establish connection between policy input methods
& policy choice.
2
WHAT IS THE COURSE ALL ABOUT?

29-Sep-20
 Students are required to extensively read on the
subject, evaluate policies in Ethiopia (process & output),
& produce policy recommendations.

 As a course output, Students will be equipped with the

necessary theoretical & technical tools of policy
analysis.

 At the end of the course, students can review policy,

participate in policy formation & produce inputs to a
policy under review. 3
COURSE CONTENTS

29-Sep-20
4
COURSES DELIVERY

29-Sep-20
 Interactive class lecture

 Active classroom participation in the form of

questions & answers & sharing their experience
in social policy analysis & project planning

 Individual & group assignment+ classroom

presentation

 Each day you will be expected to read on specific

issue for class discussion. 5
INTRODUCTION

29-Sep-20
 What is policy?
 Policy is often associated simply with legislation
& regulation, but in reality it encompasses a
wide variety of activities
 A policy often comes in the form of general
statements about priorities, written regulations
or guidelines, procedures &/or standards to be
achieved
 At its simplest, policy refers to a distinct path of
action which is suitable for the pursuit of desired
goals within a particular context, directing the
decision making of an organization or individual 7
INTRODUCTION

29-Sep-20
 Generally speaking public policy is what the
government chooses to do, or not to do.
 It is a decision made by government to either act, or
not act in order to resolve a problem ( e.g. poverty,
unemployment…)
 Lowi & Ginsburg (1996, 607), define public policy as ―an
officially expressed intention backed by a sanction,
which can be a reward or a punishment‖
 Public policy is a course of action that guides a
range of related actions in a given field. They rarely
tackle one problem, but rather deal with clusters of
entangled & long-term problems
8
 29-Sep-20
 Public policy provides guidance to governments &
accountability links to citizens
 Most issues tend to involve deeply held values/
interests and large amounts of money, making
the policy process very complex.
 Decision making is clouded by values, rather
than based purely on objective data.
 PP is determined by ―politicians‖
 PP is influenced by stakeholders and interests

 The foundation of public policy is composed of 9

national constitutional laws & regulations.
INTRODUCTION

29-Sep-20
 Public policy is concerned with:
 How are problems and issues defined &
constructed?
 How are they placed on political & policy agenda?
 How policy options emerge?
 How & why governments act or do not act
 What are the effects of government policy?

 No single discipline, integrates what seems useful for

understanding
10
INTRODUCTION

29-Sep-20
 What is the difference between a policy and a strategy?

 A Strategy is a special plan made to achieve a

market position & to reach the organizational goals
& objectives,

 but Policy refers to a set of rules made by the
organization for rational decision making.

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 29-Sep-20
Good policy has the following seven
characteristics/features

 Endorsed – The policy has the support of many

stakeholders
 Relevant - The policy is applicable to the organization
 Realistic – The policy makes sense
 Attainable – The policy can be successfully
implemented
 Adaptable – The policy can accommodate change
 Enforceable – The policy is statutory
 Inclusive – The policy scope includes all relevant
parties 12
 29-Sep-20
 Policy analysis describes investigations that
produce accurate & useful information for
decision makers

 Policy analysis is an applied social science

discipline which uses multiple methods of
inquiry & argument to produce & transform
policy -relevant information that may be
utilized in political setting to resolve policy
problems

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 29-Sep-20
 Policy analysis is a set of techniques & criteria
with which to evaluate public policy options &
select among them
 rationalize the development & implementation of
public policy & as the means to greater efficiency
& equity in allocation of public resources
 Analysis of existing policy--which is analytical &
descriptive—i.e., it attempts to explain policies &
their development.
 Analysis for new policy - which is prescriptive—
i.e., it is involved with formulating policies &
14
proposals (e.g- to improve social welfare
 29-Sep-20
 Policy analysis describes investigations that produce
accurate & useful information for decision makers
 The methodology of policy analysis draws from & integrates
elements of multiple disciplines  Political science,
Sociology, Psychology, Economics, & Philosophy
 What effects does the policy have on the targeted problem?
 What are the unintended effects of this policy? Unintended
effects
 What are the effects of this policy on different population
groups? Equity
 What is the financial cost of this policy (some analysts also
include tax credits in this analysis)? Cost
 Is the policy technically feasible? Feasibility
 Do the relevant policy stakeholders view the policy as
acceptable? Acceptability
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DIFFERENT MODELS OF POLICY ANALYSIS

 Institutional  Group model

model  Elite model
 Process model  Public choice model
 Rational model  Game theory model
 Incremental
model

16
INSTITUTIONAL MODEL

 Policy as institutional output

 It was assumed that changes in structure will affect
policy contents
 The reality is that both structure & policy area
largely determined by social & economic forces

17
PROCESS MODEL

 This model focuses on:

 Identification of issues
 Setting agenda
 Formulation of policy proposals
 Legitimization of policy implementation

 This model is criticized for being linear & simplistic.

 In real world stages of policy process may overlap or
never happen. But this model is widely used in policy
analysis
18
RATIONAL MODEL

 Rational policy aims to achieve ―maximum social gain‖

 Policies resulting in gains to the society that exceed
cost by the greatest amount.

 Policy is rational when the difference between the

value it achieves and the value it sacrifices is positive
& greater than any policy alternative.

 Rationalism involves the calculation of all social,

political, and economic values sacrificed or achieved
not that can be measured in monetary terms 19
RATIONAL MODEL

 This requires that policy maker must know :

 All the society‘s value preferences & their relative

weights
 All available policy alternatives
 The consequences of each alternative
 Calculate the ratio of benefits to cost for
each alternative
 Select the most efficient policy alternative
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INCREMENTAL MODEL

 Under this model policy is continuation of previous

policy with minimum changes.

 Existing programs, policies and expenditures are

considered are as base.

 Policy makers accept the legitimacy of previous

policies because of the uncertainty about the
consequences of the new policies.

21
GROUP MODEL

 Under this model, interaction among groups is

regarded as central fact of policy making.

 Public policy at any given time is the equilibrium

reached in group struggle.

 Group model regards all meaningful, political activity

in terms of group struggle.

22
PUBLIC CHOICE MODEL

 This model assumes that all political actors , voters,

taxpayers, legislatures, bureaucrats, parties etc. seek to
maximize their personal benefits in politics as in
market place.

 Individuals come together in politics for their mutual

benefit, just as they come together in market place.

23
GAME THEORY MODEL

 It studies rational decisions in situations in which

two or more participants have choices to make &
outcome depends on the choices made by each.

 Game theory is an abstract & deductive model of

policy making

 It does not describe how people actually make

decisions but rather how they should go about
making decisions in competitive situations if they
are rational
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USEFULNESS OF PA MODELS
 Order and simplify reality

 Identify what is significant

 Be congruent with reality

 Provide meaningful communication

 Direct enquiry and research

 Suggest explanations
25
CONCLUSION ON MODELS

 Models are not competitive ; any one of them could not

be judged best

 Each one provides a separate focus and each can help

to understand different things about public policy

 Most policies are combination of rational planning,

incrementalism, interest group activity, elite
preference, game playing, public choices, &
institutional preferences
26
CHAPTER TWO: INEQUALITY, POVERTY
AND DEVELOPMENT

29-Sep-20
 Poverty:
• The situation in which an individual is not able to
afford an adequate standard of living, i.e. not
able to buy clothing, food or shelter.
• The level may vary from country to country.
• In general, Poverty is lack of income; lack of drinking
water, lack of access to health care and lack of
protection against adverse shocks.
 Poverty Line:
 The level of income below which an individual is not able to
pay for his subsistence. It may vary from place to place.

 Inequality:
 The situation of not being equal, in particular in reference
to the distribution of income among the population 27
Absolute Poverty:
• The deprivation of basic needs (food, clothing, shelter,
health, health care, and education.
Relative Poverty:
• It is defined as contextually as economic inequality in the
location or society in which people live.

Poverty Facts:
•Almost half of the world, -over 3 billion people-live on less
than USD 2.5 day.
• More than 80% of the world population live in countries
where income differentials are widening
• The poorest 40% of the world‘s population accounts for 5%
of global income.
• The richest 20% accounts for 75% of world income
1. What‘s so bad about inequality?

• Extreme income inequality leads to inefficiency.

•Lack of access to credit leads to under-financing of good
productive opportunities.
•Since the middle-class has the highest average and
marginal saving rates, income inequality leads to lower
saving and investment.

• Extreme income inequality also leads to inefficient

allocation of assets.
•Overemphasis on higher education to the detriment of
basic education.

•Inefficiently large farms next to inefficiently small farms.

2. What‘s so bad about inequality?
•Extreme income inequality leads to political and social
instability
The poor try revolution while the rich try corruption and
rent-seeking to retain power.
•Most people think it‘s unfair/unjust.
Rawls‘s ―veil of ignorance.‖ A sense of unfairness lowers
welfare.
 Measuring Inequality and Poverty
Measuring Inequality
 for both analytical & quantitative purposes, it is important to
distinguish between two principal measures of income distribution

 Size distribution: Personal or size distribution of income deals

with the individual persons or households and the total income
they receive

 Functional distribution: Functional or factor share distribution

of income uses the share of total national income that each of the
factors of production receives. i.e. The distribution of income to
factors of production without regard to the ownership of the factors.
I) Size distribution:
A) Quintiles and Deciles: ( fifths and tenths)

 Divide the population into successive quintiles or deciles

according to ascending income levels and then determine the
proportion of net income received by each income group

 Common measure of income inequality is the ratio of incomes

received by the top 20% and bottom 40% of the population
TABLE 1 TYPICAL SIZE DISTRIBUTION OF PERSONAL INCOME IN A
DEVELOPING COUNTRY BY INCOME SHARES—QUINTILES AND DECILES
B) Lorenz curves:

Show the actual quantitative relationship between the percentage of

income recipients and the percentage of total income they received
during a time period (year)

Depict the variance of the size distribution of income from perfect

equality
 FIGURE 1 THE LORENZ CURVE

Arrange population
according to the share of
income they receive, from
lowest to highest.

Calculate cumulative
percentages (the lowest 5%,
the lowest 45%, etc.)

Plot the cumulative

percentage of households
against the cumulative
percentage of the income
they earn.
C) Gini coefficient

Is measured graphically by dividing the area between the

perfect equality line and the Lorenz curve by the total area lying
to the right of the equality line in a Lorenz curve diagram

Ranges in value from 0 (perfect equality) to 1 (perfect

inequality)
Figure 2
FIGURE 3 THE GREATER THE CURVATURE OF THE LORENZ LINE, THE
GREATER THE RELATIVE DEGREE OF INEQUALITY
 FIGURE 4 FOUR POSSIBLE LORENZ CURVES

Which is the
least unequal
country?
Which is the
most unequal?
Can we rank
them all?
Desirable Properties of Gini coefficient (and Loreze Curve and
coefficient of variation):
•It‘s anonymous: it doesn‘t treat some people as better than
others, it just reports their income.
•It‘s scale-independent: measuring income in dollars or in rupees
doesn‘t change it.
•It‘s population-independent: changing the amount of people but
keeping income distribution constant doesn‘t change it.
•It follows the transfer principle: transferring income from a
richer to a poorer person (without changing their order) improves
it (Pigov-Dalton Principle)
Gini Map 2008
In 2019, some 70 percent of the world's poor will live in Africa, up
from 50 percent five years ago. By 2023, Africa's share will rise to over

29-Sep-20
80 percent (up from 60 percent in 2016).

43
D) Coefficient of Variation (CV)

•Is sample SD divided by the sample mean

•It also satisfies the properties of anonymity, scale independence,
population independence, and transfer principles
Example:
CV=0.20-0.35, equitable distribution
CV= 0.50-0.70, high inequality

N.B: All inequality measures are measuring relative income

MEASURING ABSOLUTE POVERTY
 A situation where a population or sections of the population
are not able to maintain minimum levels of living.
 Measuring Absolute Poverty
 Headcount (H): simply adds the number of people whose
income is below an agreed upon poverty line.
 Headcount Index (H/N): simply divided H by population
Total poverty gap (TPG):

• A measure of total amount of income necessary to raise

everyone who is below the poverty line up to the line

TPG   (Yp  Yi )
H

i1 and Y the income of

Where Yp is the absolute poverty line; i
the ith poor person


THE MULTIDIMENSIONAL POVERTY INDEX (MPI)

 It is a newly introduced measurement by UNDP since 2010. It

follows the following steps:
 Identification of poverty status through a dual cut-off:
 First, cut-off levels within each dimension (analogous to falling
below a poverty line for example $1.25 per day for income
poverty);
 Second, cut-off in the number of dimensions in which a person
must be deprived (below a line) to be deemed multidimensionally
poor.

 MPI focuses on deprivations in health, education, and standard of

living; and each receives equal (that is one-third of the overall total)
weight.
 MPI INDICATORS
 Health - two indicators with equal weight - whether any child has died in the
family, and whether any adult or child in the family is malnourished –
weighted equally (each counts as one-sixth toward the maximum deprivation
in the MPI)
 Education - two indicators with equal weight - whether no household
member completed 5 years of schooling, and whether any school-aged child
is out of school for grades 1 through 8 (each counts one-sixth toward the
MPI).

 Standard of Living, equal weight on 6 deprivations (each counts as 1/18

toward the maximum): lack of electricity; insufficiently safe drinking water;
inadequate sanitation; inadequate flooring; unimproved cooking fuel; lack of
more than one of 5 assets – telephone, radio, TV, bicycle, and motorbike.
N.B: It removes income measurement from the dimension, counted as a
limitations of MPI .
29-Sep-20
49
Growth and inequality:
•High overall growth may or may not be accompanied by improved
income for the poorest 40%.
Low growth may or many not lead to low growth of the
incomes of the poor.
•The poor almost always share in (some of) the benefits of growth.
•But whether growth leads to less inequality depends on who does the
growing
Relation between economic growth and
inequality:
•Does growth affect the level of inequality?

No consensus

•Does initial inequality affect growth?

• Negative relation between growth and initial

inequality in income (refer to Why is inequality bad?)
• Positive relation between growth and initial inequality
(only Forbes found this relation)
• Initial inequality in assets and human capital
negatively affects growth (as it hurts the poor the most)

•The main flow of causation appears to be initial

inequality hampering growth and not the other way
Relation between economic growth and poverty:

• Traditionally, it was considered that there is trade-off

between growth and poverty.

•Why are similar rates of growth associated with

different rates of poverty reduction?

1. Redistribution of growth benefits reduces

poverty
2. Initial inequality in income enhances poverty
3. Sectoral composition of growth (agriculture
versus modern, rural versus urban)

•Efforts to reduce poverty lead to higher growth and

higher growth leads to reduction in poverty.
Growth and poverty

•―Growth is bad for the poor. They are marginalized

from modernization, so inequality rises and even
absolute poverty may rise as jobs disappear.‖

•―Poverty/Inequality-reduction programs are bad for

growth. And redistribution curtails incentive for
saving and work.‖

•―The poor save a surprisingly large proportion of

their income. And extra income for the poor is
invested into better nutrition, education, health.‖

• When it is inclusive, growth reduces poverty. Lower

extreme poverty may also lead to higher growth
Growth and poverty

•Growth comes from taking advantage of profitable

opportunities. If the poor can‘t invest because they don‘t
have access to credit, fewer profitable opportunities will be
taken. Then poverty/inequality-reduction is good for growth.

•Unlike the elites of the Industrial Revolution, today‘s Third-

World elites are not high savers and do not devote large
resources to improving the productivity of their business
concerns. Poverty and destitution lead to unproductive
workers.

•Higher incomes for the poor create a strong domestic

market.

•Poverty/Inequality reduction generates support for

development policies and programs.
•In general, there‘s no simple relation between
poverty/inequality and per capita income.
1. Inequality (high or low) seems to be very
persistent; but it typically changes (up or down)
when output per capita changes.
2. There might be a complicated relation, involving
the interaction of many factors.

•Inequality is probably determined by

1. history
2. social cleavages,
3. politics and government policies

•Careful statistical/econometric analysis is necessary to

identify the effect of each factor.
Is Growth Good for the Poor?
No, if it‘s
Jobless
Is growth labor-
intensive?
Ruthless
Does inequality worsen?
Voiceless
Does democracy
Rootless
expand?
• Are people able to retain
their cultural identity?
Futureless
• Does growth squander
resources for future
generations?
Is Growth Good for the Poor?
Yes, if it is accompanied by
1. Expanded opportunity
Are the losers compensated by the
winners?
Is competition open and fair?
Are services (education, health,
transportation, communication)
good and reliable?
2. Macroeconomic stability
Are the costs of stabilization worth
the benefits?
3. Specialization in the country‘s
comparative advantage
• Are the reduction of poverty and the acceleration of growth in
conflict? OR are they complementary?

• Traditionally, rapid growth is bad for the poor because they

would be bypassed and marginalized by the structural change
of modern growth.

• Beyond this, there had been considerable concern in policy

circles that public expenditure required for poverty reduction
would entails a reduction in the rate of economic growth,
paralleled the arguments that countries with lower inequality
would experience slower growth.

• If there were redistribution of income from rich to poor, the

concern was expressed that saving would fall. However, the
marginal savings are not small.
• There are at least five reasons why policies focused towards
reducing poverty levels need not lead to a slower rate of
growth:

1.Widespread poverty creates conditions in which the poor

have no access to credit, are unable to finance their basic
needs, causing the per capita growth to be less than what it
would be if there were greater equality.

2.Unlike the historical experience of the now developed

countries, a wealth experience data tells us that the rich in
many contemporary poor countries are generally not noted
for their frugality or for their desire to save and invest
substantial proportions of their incomes in their local
economy.

3.The low incomes and low levels of living for the poor can
lower their productivity, a slower economic growth.
4. Raisingthe income level of the poor will stimulate an overall
increase in the demand for locally produced necessity products
where as the rich tend to spend more of additional incomes on
imported luxury goods.

5. A reduction in mass poverty can stimulate healthy economic

expansion by acting as a powerful material and psychological
incentives to widespread public participation in the
development process.

Therefore,

“ certainly, the relationship between growth and progress among the

poor does not by itself indicate causality. Some of the effects probably
runs from improved income, education and health among the poor to
foster the overall growth. Moreover, poverty reduction is possible
without rapid growth. But, whatever the causality, it is clear that
growth and poverty reduction are entirely compatible objectives”
(Todaro and Smith, 2011)
 Policy Options on Income Inequality
& Poverty
1) Areas of Intervention
 Altering the functional distribution of income through
policies designed to change relative factor prices
Removal of factor price distortions
 Give more income to labor and less to capital.

 Mitigating the size distribution: Modifying the size

distribution through progressive redistribution of asset
ownership
 Redistribution policies such as land reform
 Change asset and skill inequality: the sources of
income inequality: Land reform; microcredit; basic
education
 Mitigating the size distribution: Reducing the size
distribution at the upper levels through progressive income
and wealth taxes

•Direct progressive income taxes

•Indirect taxes

 Direct transfer payments and the public provision of goods

& services

•Workfare programs superior to welfare and handouts.

• Poverty reduction programs: direct transfers or subsidies

for food, education, health, etc.
2. Policy options are

A) Changing relative factor prices

 Traditional-sector workers have very low incomes and
minimum-wage laws are seldom enforced.
 Artificially high modern-sector wages (due to unions or
laws) reduce the growth of the modern sector,
condemning more people to poverty and exclusion.
 Market-determined wages (which would be lower) in
the modern sector would increase employment and
incomes for the poor.
 Market-determined cost of capital (which would be
higher) would encourage firms to hire workers rather
than buy capital.
B) Transfer payments and public provision of goods and
services
•Make sure it‘s targeted to the poor.
•Prevent the poor from becoming dependent on it … but
encourage appropriate risk taking.
•Discourage switching from work to program.
•Avoid resentment by nearly-poor-but-not-enough who are
working. is better than welfare if it
C) “workfare”
•Does not undermine incentives for acquiring human
capital needed for private sector jobs
•Increases net benefits – including externalities
•Is difficult to identify the needy without work
requirement
•There are relatively few poor people
•There less social stigma / political resentment from
workfare
D) The need for a „package‟ of policies

•Eliminate price distortions: more efficiency, more

employment and less poverty
•Structural change in asset ownership
•Progressive taxes and transfers; safety net
• Policies to correct factor price distortions
•Policies to change the distribution of assets, power, and
access to education and associated employment
opportunities
•Policies of progressive taxation and directed transfer
payments
•Policies designed to build capabilities and human and
social capital of the poor
Ha-Joon Chang ( 2011)

Economic Growth and Economic Development

29-Sep-20
Economic development as the development of productive capabilities
• If Equatorial Guinea has grown so much faster than China, why have
we not heard of the ‗Equatorial Guinean economic miracle‘, when we
hear about the ‗Chinese economic miracle‘ all the time? Nothing about
the country‘s economy changed other than finding a very large oil
reserve in 1996.
• Without oil, the country would be reduced to one of the poorest in the
world once again, which it used to be, as it cannot produce much else
• What makes Equatorial Guinea different from those other cases is that
its growth has not been achieved through an increase in its
ability to produce.

• Equatorial Guinea‘s experience powerfully illustrates how economic

growth, that is, the expansion in the output (or income) of the
economy, is not the same as economic development.
66
• process of economic growth that is based on the increase in an
economy‘s productive capabilities: its capabilities to organize – and,
more importantly, transform – its production activities.
CHAPTER THREE
POPULATION GROWTH & ECONOMIC DEVELOPMENT

68
POPULATION GROWTH

Population is the key determinant factor for development.

 A purse
―A growing population is the most important factor for the
increase in the income of nation.‖ Adam Smith (in Wealth
of the nations)

 Boserup believed that people have the resources of

knowledge and technology to increase food supplies

 or a curse?
 ―Population grows at a geometric rate & Food supplies
increase only at an arithmetic rate, leading negatively
affect growth‖ Malthus

69
MEASURES OF POPULATION
 Population density- how much land in relation
to population: Two types of density
 Man-land or Arithmetic Density: number of
persons/ area—often unrealistic because it
assumes an even distribution of people
 Physiological or Nutritional Density-
number of persons/ cultivated area—more
realistic

70
 Crude birth rate- Number of live births per 1K
population
 Fertility ratio- Number of children < 5 years per 1K
women of child bearing age (15-44)
 Crude death rate- Number of deaths per 1K
population
 Infant mortality rate- Number of deaths 0-1 years/
Per 1K live births
 Dependency Ratio- Young (< 15 years) + Aged (> 65
years)/ Adult (15- 64 years)
71
WORLD POPULATION DISTRIBUTION BY
REGION, 2010 AND 2050

72
 The Hidden Momentum of Population Growth
 High birth rates cannot be altered overnight

 Age structure of developing country populations

73
POPULATION PYRAMIDS: ALL DEVELOPED &
DEVELOPING COUNTRIES AND CASE OF ETHIOPIA

74
THE DEMOGRAPHIC TRANSITION

 Stage I: High birthrates and death rates

 Stage II: Continued high birthrates, declining

death rates

 Stage III: Falling birthrates & death rates,

eventually stabilizing

75
THE DEMOGRAPHIC TRANSITION IN
WESTERN EUROPE

76
IMPACT OF POPULATION GROWTH

77
SOME POLICY APPROACHES
 What developing countries can do:
 Long run: increase the price of child
 opportunity cost of mother‘s time Cd
 Cost of educating child 0
Pc
 Short run: control fertility
 Persuade people
 Family-planning programs

 Economic incentives and disincentives

 Redistribute population

 Coerce people

 Raise women‘s social and economic status

 29-Sep-20
Chapter Four
The Human Capital Approach to
Development

79
 29-Sep-20
 Health & education are important objectives of
development, as reflected in Sen‘s capability
approach, & in the core values of economic
development

 Health & education are also important

components of growth & development – inputs in
the aggregate production function

80
 29-Sep-20
 Education & Health as Joint Investments for
Development
 These are investments in the same individual
 Greater health capital may improve the returns to
investments in education
 Health is a factor in school attendance
 Healthier students learn more effectively
 A longer life raises the rate of return to education
 Healthier people have lower depreciation of education
capital
 Greater education capital may improve the returns to
investments in health
 Public health programs need knowledge learned in 81
school
 Basic hygiene and sanitation may be taught in school
 29-Sep-20
 Improving Health & Education: Why Increasing
Incomes Is Not Sufficient
 Increases in income often do not lead to
substantial increases in investment in children‘s
education & health
 But better educated mothers tend to have
healthier children at any income level
 Significant market failures in education & health
require policy action

82
 29-Sep-20
 Investing in Education & Health: The Human
Capital Approach
 Initial investments in health or education lead to
a stream of higher future income

 The present discounted value of this stream of

future income is compared to the costs of the
investment

 Private returns to education are high, & may be

higher than social returns, especially at higher 83
educational levels
HUMAN CAPITAL AND
ENDOGENOUS GROWTH THEORY

29-Sep-20
 Motivation: Traditional neoclassical growth
theory failed to explain long term growth.

 There is convergence, MPK eventually declines.

 Technological Advances may eliminate

convergence, but they are Exogenous in the
model-

 The growth model itself does not explain the

technical advancement, & technical innovation
happens out of blue, & is injected into Solow 84
Model.
ENDOGENOUS GROWTH MODEL

 The new theory (EGM) provides a theoretical

framework for analyzing endogenous growth,
persistent GNP growth that is determined by the
system governing the production process rather than
by forces outside that system
 More succinctly, the theory tries to explain the factors
that determine the size of the rate of growth of GDP
that is left unexplained & exogenously determined in
the Solow neoclassical growth equation (Solow
residual).

85
 Different assumptions & conclusions from neoclassical
models
 No diminishing returns to capital assumption in the new
theory sustained long-term growth resulting from
increasing returns to scale.
 Perhaps the most interesting aspect of endogeneous growth
models is that they help explain anomalous international
flows of capital that deepens wealth disparities between DCs
& LDCs.
 The potentially high rates of return on investment offered by
LDCs with low K/L ratios are greatly eroded by lower levels
of ―complementary investments‖ in human capital,
infrastructure, or research & development.
 Shortcoming of the new growth theory: it remains dependent 86
on a number of traditional neoclassical assumptions that are
often inadequate for LDCs.
 Endogenous growth theory tries to overcome the
shortcoming of exogenous growth model by building
macroeconomic models out of microeconomic foundations.
 Households are assumed to maximize utility subject to
budget constraints while firms maximize profits. Crucial
importance is usually given to the production of new
technologies and human capital.
 The engine for growth can be as simple as a constant return
to scale production function (the AK model) or a Romer
model of more complicated set ups with spillover effects.
 The new growth theory provides a theoretical framework
for analyzing endogenous growth, persistent growth that is
determined by the system governing the production process
rather than by forces outside that system. 87
 This model discards the classical assumption of diminishing
marginal return on capital investments, assuming public &
private investment in human capital generate external
economies & production improvement that offset the
natural tendency for diminishing returns & explain the
existence of increasing returns to scale
 In particular, the Romer model addresses technological
spillovers that may be present in the process of
industrialization.
 It starts from the firm or industry level for growth process
considering economy- wide capital stock, positively affects
output at the industry level so that there may be increasing
return to scale at the economy wide level. 88
 Reemphasizes the importance of saving for fast economic growth
(similar to neoclassical approaches)

 Suggest active role of public policy (government) to provide public

goods (infrastructure) so as to encourage private investment &
efficient allocation of resources (contrast to the neoclassical
approaches that adhere strict dogma of free market & passive
governments).

 Underlines that the potentially high rate of returns to investment in

LDC is hindered by low level of complementary investments in
human capital (education), infrastructure and research.

N.B: However, both endogenous & exogenous models fail to look

into the growth problems of LDCs that arise mainly from 89
inefficiencies due to inadequate institutional structure, &
imperfect capital and goods markets.
 Endogenous Economic Growth Model
 New Explanatory Variables

- Human Capital with Knowledge; It is separate

Physical Capital with Technical Innovation; we can
have an accumulation/evolution function for Human
Capital

- Other variables measuring quality of human factors

may be tried
 No convergence – MPK does not have to decline 90 if
there is an increase in Human Capital
 The contribution of this model is that it emphasizes
the link between technical innovation, Human Capital,
& Institutions including Government

 The previous Neo-Classical economists emphasized the

close relationship between Technical Innovation &
Physical Capital

91
 Technological change is the result of the intentional
actions of people, such as Invention, and Research &
Development

 Some institutions promote innovation and R & D, and

others inhibit R & D.

 Romer supports Government-funding for Educational

Institution and R & D.

92
GROWTH, TECHNOLOGY AND EDUCATION
Engelbrecht
– At an early stage of economic development, the
level of education plays important role in
technological catch-up

– Productivity growth is more rapid where

countries have higher levels of average schooling

– Human capital has largest effects when specific

to
sub-categories important for technological 93

diffusion (science, math, engineering)

 (1964, 1993, 3rd ed.) Human Capital: A
Theoretical and Empirical Analysis, with Special
Reference to Education. Chicago, University of
Chicago Press
 Human capital – ―our knowledge, skills learning,
talents and abilities‖ (Definition by OECD)

94
LABOR VERSUS HUMAN CAPITAL
 Labor
- Quantity of workforce
- physical
- isolated , individual

 Human Capital
- Quality of workforce
- Intellectual
- Between Humans, Institutional
95
 Unlike physical labor (and the other factors of
production), knowledge is:
 Expandable and self-generating with use: as
doctors get more experience, their knowledge
base will increase, as will their endowment of
human capital.

 The economics of scarcity is replaced by the

economics of self-generation.

 Transportable and shareable: knowledge can be

moved and shared. This transfer does not prevent 96
its use by the original holder. It is public goods
THE TECHNOLOGY OF ENDOGENOUS
GROWTH
 Endogenous grow theory makes a relative minor change
to the neoclassical production function

 It assumes that the aggregate (social) production

function is described by a C-D technology :

Y  AK  L1
 1
 AK

99
THE TECHNOLOGY OF ENDOGENOUS
GROWTH

Y  AK
 If the capital elasticity of output is equal to 1 (rather
than 1/3), this means that the economy is no longer
subject to a diminishing marginal product of capital.

MPK  A ( a constant )
100
THE TECHNOLOGY OF ENDOGENOUS
GROWTH

Y  AK
 In the neoclassical theory, the capital elasticity, α=1/3,
is proposed to be consistent with the evidence.
 How does endogenous growth theory explain this
alternative value, α=1, can be made consistent with the
fact ? (constant returns to capital )
--- This is the social technology !!

101
ENDOGENOUS GROWTH AND
ECONOMIC POLICY
 One issue that concerns contemporary policymakers is
the fact that GDP growth per capita was a little slower in
the 1970s than it was in the immediate postwar period.

-- If the neoclassical growth theory is correct, not much can

be done about this.

-- The learning-by-doing suggests that growth is related to

investment- both public and private.

103
ENDOGENOUS GROWTH AND
ECONOMIC POLICY

 Policy :

-- Investment in human capital can have great public

benefits.

-- Research & Development (R&D)

105
29-Sep-20
106
INTERNATIONAL TRADE AND FINANCE:
SOME KEY ISSUES

 Many LDCs rely heavily on exports (usually

primary products)

Wesley. All rights reserved.

Copyright © 2006 Pearson Addison-
 Many LDCs also rely heavily on imports
(typically of machinery, capital goods,
intermediate producer goods, & consumer
products)

12-
107
 Copyright © 2006 Pearson Addison-
Wesley. All rights reserved.
108
12-
TABLE 12.1
FIVE BASIC QUESTIONS ABOUT
TRADE AND DEVELOPMENT
 How does international trade affect economic
growth?

 How does trade alter the distribution of income?

 How can trade promote development?

 Can LDCs determine how much they trade?

 Is an outward-looking or an inward-looking trade

policy best?
12-
109
 Copyright © 2006 Pearson Addison-
Wesley. All rights reserved.
111
12-
TABLE 12.2
THE TERMS OF TRADE AND THE
PREBISCH-SINGER THESIS
 Total export earnings depend on:
 Total volume of exports sold AND
 Price paid for exports

 Prebisch & Singer argue that export prices fall

over time, so LDCs lose revenue unless they can
continually increase export volumes

 Prebisch & Singer think LDCs need to avoid a

dependence on primary exports
12-
113
THE TRADITIONAL THEORY OF INTERNATIONAL
TRADE
 The principle of comparative advantage
 Relative factor endowments and international
specialization: the Neoclassical model

12-
114
 Copyright © 2006 Pearson Addison-
Wesley. All rights reserved.
115
12-
FIGURE 12.1
THE TRADITIONAL THEORY OF
INTERNATIONAL TRADE
 The principle of comparative advantage
 Relative factor endowments and international
specialization: the Neoclassical model
 Trade theory and development: the traditional
arguments

12-
116
SOME CRITICISMS OF TRADITIONAL
FREE-TRADE THEORY IN THE CONTEXT
OF DEVELOPING-COUNTRY EXPERIENCE

 Six assumptions of the Neoclassical model must

be scrutinized:

12-
117
THE SIX ASSUMPTIONS
 The following assumptions of the Neoclassical
model must be scrutinized:
 Fixed resources, full employment, &
international factor immobility
 Fixed, freely available technology & consumer
sovereignty
 Internal factor mobility & perfect competition
 Governmental non-interference in trade

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118
THE SIX ASSUMPTIONS (CONT‘D)
 Balanced trade and international price adjustments
 Trade gains accruing to nationals

12-
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12-
120
SOME CONCLUSIONS ON TRADE THEORY &
ECONOMIC DEVELOPMENT STRATEGY

 Trade can lead to rapid economic growth under

some circumstances
 Trade seems to reinforce existing income
inequalities
 Trade can benefit LDCs if they can extract trade
concessions from developed countries
 LDCs generally must trade

 Regional cooperation may help LDCs

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12-
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