ZCMG6231:

Economic Policy and

Development – Part 2
ASSOC. PROF. DR. MOHD AZLAN SHAH ZAIDI (

CENTER FOR SUSTAINABLE AND INCLUSIVE DEVELOPMENT STUDIES,

FACULTY OF ECONOMICS AND MANAGEMENT,
UNIVERSITI KEBANGSAAN MALAYSIA

&

MALAYSIAN INCLUSIVE DEVELOPMENT AND ADVANCEMENT INSTITUTE

UNIVERSITI KEBANGSAAN MALAYSIA
Economic Development Theories
• Economic development theories are frameworks and models that attempt to explain the processes and factors that
contribute to the growth and improvement of economies over time.
• These theories provide insights into the dynamics of economic development, the causes of disparities between
countries, and the strategies that can be employed to promote sustainable economic growth and improve living
standards.
• Classical Growth Theories:
– Adam Smith's Theory of Absolute Advantage: This theory emphasizes specialization and trade as a means to achieve economic
growth. Countries should focus on producing goods and services in which they have an absolute advantage.
– David Ricardo's Theory of Comparative Advantage: Similar to absolute advantage, this theory emphasizes specialization and trade
based on relative efficiency differences, even if one country is more efficient in producing all goods.

• Neoclassical Growth Theory:

– Solow-Swan Growth Model: Developed by Robert Solow and Trevor Swan, this model focuses on capital accumulation and
technological progress as drivers of economic growth. It highlights the role of investment, savings, and productivity
improvements.
Economic Development Theories
• Endogenous Growth Theories:
– Romer's Theory of Technological Change: Paul Romer's theory emphasizes the role of knowledge and innovation in driving economic
growth. A key idea is that knowledge is a non-rivalrous resource that can be shared and used to create new technologies.
– Human Capital Theory: Developed by Gary Becker, this theory emphasizes the importance of education and human capital formation as
crucial factors in economic development.

• Structuralist Theories:
– Dependency Theory: This theory, associated with scholars like Raúl Prebisch, argues that the global economic system perpetuates
underdevelopment in poorer countries. It emphasizes the unequal relationships between developed and developing nations.
– Dual Economy Model: Developed by Arthur Lewis, this model describes the coexistence of a traditional agricultural sector with a modern
industrial sector. It explains the process of labor migration from the agricultural sector to the industrial sector as a driver of development.

• Institutional Theories:
– Institutional Economics: This theory focuses on the role of institutions, both formal (laws, regulations) and informal (social norms, culture), in
shaping economic development. Institutions can facilitate or hinder economic growth.
– New Institutional Economics: Building on institutional economics, this theory examines how institutions affect economic behavior and
incentives, which in turn influence economic development.
Economic Development Theories
• Developmental State Theory:
– Developmental State Theory: This theory emphasizes the active role of the state in guiding economic development. It suggests
that certain policies, such as industrial policies and targeted interventions, can accelerate economic growth and structural
transformation.

• Modernization Theory:
– Modernization Theory: This theory posits that societies go through stages of development as they adopt modern institutions and
values. Economic growth is seen as a natural outcome of this modernization process.

• Sustainable Development Theories:

– Sustainable Development Theory: Emphasizes the importance of balancing economic growth with environmental conservation
and social well-being to ensure long-term development.
Classical Growth Theories
• Adam Smith's Theory of Absolute Advantage
– Absolute advantage refers to a situation in which one country, individual, or entity can produce a good or
service using fewer resources (inputs such as labor, capital, and materials) than another country, individual, or
entity. In other words, it is the ability to produce more output with the same amount of resources or the same
output with fewer resources compared to others.

• David Ricardo's Theory of Comparative Advantage

– Comparative advantage refers to a situation in which one country, individual, or entity can produce a good or
service at a lower opportunity cost (in terms of other goods and services foregone) than another country,
individual, or entity. It focuses on the relative efficiency of producing different goods rather than the absolute
efficiency.
Classical Growth theory
• Absolute Advantage
– e.g – Assume each country utilizes 10 workers

Textile Wheat
Country A 30 100
Country B 25 60

– Country A has an absolute advantage in producing Textile

– Country A has an absolute advantage in producing Wheat
Classical Growth theory
• Comparative Advantage
– e.g – Assume each country utilizes 10 workers

Textile Wheat

Country A 30 100
Country B 25 60
Opportunity cost of producing
Country A 100/30 = 3.33 30/100 = 0.30
Country B 60/25 = 2.4 25/60 = 0.42

– Country A has a comparative advantage in producing wheat

– Country B has a comparative advantage in producing textile
– Thus country A specializes in producing wheat, while country B specializes in
producing textile
Classical Growth theory
• Comparative Advantage - Specialization
– e.g – Assume each country utilizes 10 workers

Textile Wheat

Country A 0 200
Country B 50 0

– Thus country A specializes in producing wheat, while country B specializes in

producing textile
Exogenous growth theory
• The accumulation of capital

• The golden rule level of capital

• Population growth

• Technological process in the Solow model

Exogenous growth theory
The accumulation of capital

• Solow-Swan growth model – to show how growth in capital stock, growth in

the labor force, and advances in technology interact in an economy as well as
how they affect a nation’s total output and services.

• for now assume the labor force and technology are fixed.

• The supply of goods and the production function

• production function – output, capital stock and labor force

Y = F(K,L)

• The production function has constant return tu scale

zY = F(zK,zL)

• output per worker is a function of capital per worker

Y/L = F(K/L,1)

y = f(k)

• MPK – slope of the production function

 y

Production Function
f(k) Y = F(K,L)
Y = F(K, L)
L L L
y = f(k)
22 y = Marginal product of capital = slope of production function
20
C k
16 B

10
A

1 2 3 4 5 k
 • Growth in the capital stock and the steady state

y y=c+i
k
i = sf(k) ➔ s, saving rate

f(k) = c + sf(k)
y= f(k)
c = f(k) – sf(k)
Output per worker
100

sf(k)
MPk = , the condition that maximize the
C consumption
40

I
kg* k* k* k
Exogenous growth theory
The accumulation of capital
Y = 10000
• The demand for goods and the consumption function Y=C+S
s = saving rate
• comes from consumption and investment S = sY
• shown in term of per worker C = (1-s)Y

y=c+i y

• People save a fraction, s of their income and consume a

fraction (1 – s)
c = (1 - s)y = y - sy Output per
f(k)

worker
y = (1 - s)y + i = y – sy + i
i = sy we know that y = f(k) Consumption per worker
sf(k)
• Growth in the capital stock and the steady state
Investment per worker
i = sf(k)

c = f(k) – sf(k) k
Exogenous growth theory
y
The accumulation of capital
• two forces influence the capital stock; investment and Y = bX
depreciation
• investment cause the capital to rise while a
depreciation cause the capital to fall
i = sy x

i = sf(k)
• The amount of capital that depreciates each year is
δk
• Change in capital stock = Investment -
Depreciation
k = i - δk
 Exogenous growth theory
The accumulation of capital
• Change in capital stock = Investment - Depreciation
k = i – δk = sf(k) – δk = 0 ➔ sf(k) = δk

• at k*, sf(k) = δk or k = 0.
• k* is the steady state level of capital, the long run
equilibrium of the economy
• when k < k*, sf(k) > δk, capital stock increases
• when k > k*, sf(k) < δk, capital stock decreases
Exogenous growth theory
• How saving affect growth
• saving rate is a key determinant of the steady state capital stock

y δk

s2f(k)

s1f(k)

k*1 k*2 k
Exogenous growth theory
• The golden rule level of capital
• high saving, high income. But is high saving good?
• Consumption is important part of an economy
• Golden rule level of capital – the steady state value of k that maximizes consumption
• find the steady state consumption per worker
y=c+i
c=y–i
• substitute steady state value for output and investment
c* = f(k*) – δk*, since i = δk at steady state
Exogenous growth theory
• The golden rule level of capital
• if k < k*gold – an increase in k raises
output more than depreciation and
consumption rises
• if k > k*gold - an increase in k
reduces consumption because the
increase in output is less than the
increase in depreciation
• at the golden rule level, the
production function and the δk* line
have the same slope, so MPK = δ
Output per worker y
k
f(k)

s3f(k)
MPk = 
s2f(k)

sgf(k)
s1f(k)

Investment per worker

k* k*g k* k* k

Consumption per worker

Exogenous growth theory
• The golden rule level of capital
• if policymaker decides to increase k* to k*+ 1, the extra output would be
f(k* + 1) – f(k*) = MPK
• the extra depreciation from having 1 more unit of capital is the
depreciation rate , δ
• thus if MPK – δ > 0, consumption increases and vice versa.
• thus at the golden rule level of capital, MPK – δ = 0
Exogenous growth theory
• The golden rule level of capital
c* = f(k*) – δk*
δc/δk = f’(k*) – δ = 0
as f’(k*) = MPK
MPK – δ = 0
• economy does not gravitate toward
the golden rule steady state. So
need to set saving rate to produce
the golden rule level of capital
• if s > sgold, or s < sgold,
consumption will be lower than
the golden rule steady state.
Exogenous growth theory
Population growth
• population and labor force now grow instead of
assuming them fixed
• when the number of worker increases, capital per
worker falls k = K/L
k = i – (δ + n)k where k = sf(k) – (δ + n)k n = growth
rate of population

• (δ + n)k is breakeven investment, the amount of

investment necessary to keep constant the capital stock
per worker k.
• if k < k*, investment is greater than break-even
investment, so k rises
• if k > k*, investment is less than break-even
investment, so k falls
 Exogenous growth theory
• Now number of labour grows at n rate
• Technology also change (ie productivity increases = labour efficiency) at g rate
(δ+n+g)k =breakeven line  = depreciation rate
(δ+n)k =breakeven line n = growth rate
y
δk g = efficiency rate of worker
f(k)

s1f(k)
k steady state at golden rule level

• MPk =  (labour and technology fixed)

• MPk =  + n (technology fixed)

• MPk =  + n + g

k*3 k*2 k*1 k

Exogenous growth theory
• The effect of population growth
• alters basic Solow model in three ways
• explain sustained economic growth (in
total output). As n grows, k and y must also
grow at rate n
• explain why some countries are rich and
others are poor. The model predicts that
countries with higher population growth
will have lower levels of GDP per person.
• when n rises, break-even investment line
shift upward, k* as well as y falls.
Exogenous growth theory
• The effect of population growth
• alters basic Solow model in three ways
• affects criterion for determining the golden rule (consumption-maximizing)
level of capital.
• c=y–i
c* = f(k*) – (δ + n)k*
• the level of k* that maximizes consumption is when
MPK = δ + n or
MPK – δ = n
Exogenous growth theory
Technological progress in the Solow model
• Production function with the efficiency of labor
Y = F(K,L)
Y = F(K, L x E)
where E is the efficiency of labor
• knowledge about production methods- technological improvement.
• health, education and skills also affect the efficiency of labor
• L x E can be intrepreted as measuring the effective number of workers
• L x E grows at rate g. Eg if g = 0.03, each unit of labor becomes 3 percent more efficient
each year.
Exogenous growth theory
Technological progress in the Solow model
• The Steady state
k = K/(L x E ) = capital per effective worker
y = Y/(L x E ) = output per effective worker
thus y = f(k)
evolution of k
k = sf(k) – ( + n + g)k
where ( + n + g)k = breakeven investment
Exogenous growth theory
Technological progress in the Solow model

• The effect of Technological Progress

• at steady state

• k is constant

• since y = f(k), y is also constant y = Y/LxE =

Y/L = y x E grows at rate g

K/L = k x E grows at rate g

Y = y x E x L grows at rate g + n

• According to the Solow model, only technological progress can explain sustained growth and persistently rising
living standard.

• The golden rule level of capital

• steady state consumption per effective worker

c* = f(k*) - ( + n + g)k*

• steady state consumption is maximized if

MPK =  + n + g or MPK -  = n + g
Income Inequality and Gini Coefficient
• Income inequality refers to the unequal distribution of income among individuals
or households within a society or economy.

• It refers to a situation in which there are significant differences in the income

levels of different groups of the population.

• In an economically unequal society, some individuals or households may have

significantly higher incomes while others have relatively lower incomes.

• Income inequality can be measured using various statistical indicators, including

the Gini coefficient, the Palma ratio, the ratio of the top income percentile to the
bottom income percentile, and the share of total income held by different
income groups.
Income Inequality and Gini Coefficient
• Gini Coefficient
• The Gini coefficient is a measure of income inequality that ranges from 0 to 1,
where 0 represents perfect equality (everyone has the same income) and 1
represents maximum inequality (one person has all the income).

• Steps to calculate the Gini coefficient:

1. Arrange Incomes: Start by arranging the individual or household
incomes in ascending order, from the lowest to the highest.

2. Calculate Cumulative Shares: Calculate the cumulative shares of both

income and population. For each income level, calculate the cumulative
share of total income received by that point and the cumulative share of
the population represented by that point.
Income Inequality and Gini Coefficient
• Gini Coefficient
• Steps to calculate the Gini coefficient:
3. Plot the Lorenz Curve: Plot the Lorenz curve on a graph. The x-axis
represents the cumulative share of the population, and the y-axis
represents the cumulative share of total income. The Lorenz curve starts
at the origin (0,0) and ends at the point (1,1).

4. Calculate the Gini Coefficient: The Gini coefficient can be calculated

using the area between the Lorenz curve and the line of perfect
equality (the 45-degree line from the origin to the end point).

5. See example of calculating Gini Coefficient using Excel

Economic Development and Income Inequality –
Kuznet Curve
• The Kuznets curve, named after economist
Simon Kuznets, is a graphical representation that
depicts the relationship between economic
development and income inequality within a
society over time.

• The curve suggests that income inequality tends

to increase in the early stages of economic
development and then decrease as a country's
economy matures and reaches a certain level of
prosperity.
Economic Development and Income Inequality –
Kuznet Curve
• The Kuznets curve is shaped like an inverted U. It starts at the left side of the curve with relatively low
levels of income and inequality, then rises as income and development increase, and finally slopes
downward as income and development continue to rise.

• Early Stages of Development: In the initial stages of economic development, as a country

industrializes and urbanizes, income inequality may increase. This can be attributed to factors such as
unequal access to education, land, and economic opportunities.

• Transition Phase: As a country's economy continues to grow, income inequality may peak and then
start to decline. This turning point is often associated with structural changes in the economy,
improvements in education and skills, and the expansion of social safety nets.

• Later Stages of Development: In more advanced stages of development, the Kuznets curve suggests
that income inequality should decrease as the benefits of economic growth are more widely shared
and opportunities become more accessible to a larger portion of the population.
Economic Development Policies Implemented by
Selected ASEAN Countries
Key Aspects of Malaysia Thailand Indonesia Vietnam Phillipines
Development
1 Economic Growth New Economic Investment Promotion; Investment Promotion; Doi Moi (Renovation) Investment Promotion;
Policy; Investment Tourism Policy; Foreign Direct Tourism Development;
Tourism Promotion;
Promotion; Tourism Development; Special Investment (FDI); Micro, Small, and
Eastern Economic
and Sevices Sector; Economic Zones Tourism Promotion; Medium Enterprises
Corridor (EEC);
Financial Sector (SEZs) Financial Sector (MSMEs)
Development; Financial Sector Development; Private
Development; Sector Development
Healthcare and
Medical Tourism
2 Poverty Reduction Social Safety Nets Agricultural and Rural Agriculture and Rural Agriculture and Rural Agriculture and Rural
Development Development Development; Social Development; Social
Welfare and Poverty Welfare Programs
Reduction
Economic Development Policies Implemented by
Selected ASEAN Countries
Key Aspects of Malaysia Thailand Indonesia Vietnam Phillipines
Development
3 Human Human Capital Human Capital Human Capital Labor Force and Skills and Workforce
Development Development; Development Development Human Capital Development
Smart Cities and Development
Urban
Development

4 Infrastructure and Industrialization and Infrastructure Infrastructure Infrastructure Infrastructure

Industrialization Export-Oriented Development; Development; Development; Development;
Growth; Industry 4.0 Industry and Industrial Parks and Manufacturing and
Infrastructure Manufacturing Economic Zones Industrialization
Development
5 Governance and Public-Private Public-Private
Institutions Partnerships (PPPs) Partnerships (PPPs)
6 Trade and Global Trade Agreements Export-Oriented Trade and Export Export-Oriented Export and Trade
Integration and Export Industrialization Promotion Manufacturing; Trade Promotion
Diversification Agreements and
Export Diversification
Economic Development Policies Implemented by
Selected ASEAN Countries
Key Aspects of Malaysia Thailand Indonesia Vietnam Phillipines
Development
7 Environmental Environmental Energy and Energy and Natural Environmental Energy Development;
Sustainability Sustainability Environmental Resources Sustainability; Disaster Resilience and
Sustainability Renewable Energy and Climate Change
Green Growth Adaptation
8 Innovation and Science and Digital Economy Digital Economy Science and Information
Technology Technology; Digital Technology Technology and
Economy Business Process
Management (IT-BPM)
9 Inclusive Ekonomi MADANI Inclusive Financial Inclusion Financial Inclusion;
development Development and Healthcare and
Poverty Alleviation Universal Healthcare
Coverage