AE12 – Economic Development

Module 1: Introduction to Economic Development

Ian Dave B. Custodio

Instructor
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Lesson 3: Theories of Economic Development

Learning objectives:
a. Define theory.
b. Explain the various theories of Economic Development.
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Outline
3.1 Defining Theory
3.2 Classical Theory of Economic Stagnation
3.3 Marx’s Historical Materialism
3.4 Rostow’s Stages of Economic Growth
3.5 Vicious Circle Theory
3.6 The O-Ring Theory of Economic Development
3.7 The Lewis-Fie-Ranis Model
3.8 Dependency Theory
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3.9 Solow’s Neoclassical Growth Theory

3.10 The New Growth Theory
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3.1 Defining Theory

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Defining “Theory”
- a systematic explanation of interrelationships among economic variables.

- its purpose is to explain causal relationships among these variables, to

understand the world better and provide basis for policy.

In any event, theorists cannot consider all the factors influencing economic growth in
a single theory. They must determine which variables are crucial and which are
irrelevant.
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However, reality is so complicated that a simple model may omit critical variables
in the real world (Kindleberger and Herrick, 1977).

And although complex mathematical models can handle a large number of variables,
they have not been very successful in explaining economic development, especially in
the third world (low and middle income) countries.
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3.2 Classical Theory of

Economic Stagnation
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Classical Theory of Economic Stagnation

- based on the work of the 19th-century English
economist David Ricardo, Principles of Political
Economy and Taxation (1817).

- was pessimistic about the possibility of sustained

economic growth. For Ricardo, who assumed little
continuing technical progress, growth was limited
by land scarcity.

Image source: https://www.raptisrarebooks.com/david-ricardo-and-his-works/

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The classical economists – Adam Smith, Thomas R. Malthus, Ricardo, and John
Stuart Mill – were influenced by Newtonian physics.

Just as Newton suggested that activities in the universe were not random but
subject to some grand design, these men believed that the same natural order
determined prices, rent, and economic affairs.

In the late 18th century, Smith argued that in a competitive economy, with no
competition or monopoly, each individual will be acting according to his or her own
interest.
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A producer who charges more than others will not find buyers, a worker who asks
more than the going wage will not find work, and an employer who pays less than
competitors will not find anyone to work.

It was as if an invisible hand were behind the self-interest of capitalists, merchants,

landlords, and workers, directing their actions toward maximum economic growth.

Smith also advocated a laissez-faire (no government interference) and free-trade

policy except where labor, capital, and product markets are monopolistic.
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A major belief of Ricardo was the law of diminishing returns - referring to

successively lower extra outputs from adding an equal extra input to fixed land.

For him, diminishing returns from population growth and a constant amount of
land threatened economic growth.
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In this chart, the y-axis represents total production,

and the x-axis represents labor.

Curve OW outlines the total subsistence

wages. If the level of population (labor)
is ON, and the level of output is OP,
the per capita wage is represented by
NR. Consequently, the surplus or
profit is RG.

Source: https://corporatefinanceinstitute.com/resources/knowledge/economics/theories-of-growth/
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Because of the surplus, the capital formation

process comes into effect. Consequently, the
demand for labor increases, leading to a rise
in total wages, as the curve moves to GH.

If the total population remains constant at ON,

and wages exceed subsistence wages, i.e.
NG > NR, then total population or total
manpower will increase as the curve moves
toward OM. Because of the increase in population, surplus can be generated.
Source: https://corporatefinanceinstitute.com/resources/knowledge/economics/theories-of-growth/
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In such a manner, the process will continue

until the economy reaches point E, as depicted
by the arrow. Point E represents a stationary
situation wherein wages and total output
equalize, and no surplus can be generated.

However, according to classical

economists, with technological progress, the
production function will shift upward, as
depicted by the curve TP2.
Source: https://corporatefinanceinstitute.com/resources/knowledge/economics/theories-of-growth/
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Also, according to the Classical Growth Theory, economic stagnation can be

postponed, although ultimately not avoided.

Limitations:
1. Ignorance with respect to technology: The classical model of growth ignores the
role efficient technical progress could play for the smooth running of an economy.

2. Inaccurate determination of total wages: The classical model of growth assumes

that total wages do not exceed or fall below the subsistence level.
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3.3 Marx’s Historical Materialism

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Marx’s Historical Materialism

Karl Marx’s views were shaped by radical changes
in Western Europe: the French Revolution; the rise
of industrial, capitalist production; political and labor
revolutions; and a growing secular rationalism.

Marx opposed the prevailing philosophy and

political economy, especially the views of idealistic
socialists and classical economists, in favor of a
worldview called historical materialism.
Image source: https://www.thoughtco.com/karl-marx-biography-3026494
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Marx wanted to replace the unhistorical approach of the classicists with a historical
dialectic.

Marxists consider classical and traditional economic analysis as a still photograph,

which describes reality at a certain time. In contrast, the dialectical approach, similar
to a moving picture, looks at a social phenomenon by examining where it was and is
going and its process of change.

Marxists argued that history moves from one stage to another, from feudalism to
capitalism to socialism up to communism.
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3.4 Rostow’s Stages of

Economic Growth
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Rostow’s Stages of Economic Growth

In The Stages of Economic Growth (1961),
Walter W. Rostow, an eminent economic historian,
sets forth a new historical synthesis about the
Beginnings of modern economic growth.

Rostow theorized the five (5) stages for

economic growth.

Image source: https://www.economist.com/obituary/2003/02/20/walt-rostow

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The five stages are:

1. The traditional society
2. The preconditions for takeoff
3. The takeoff
4. The drive to maturity
5. The age of high mass consumption

Image source: https://www.e-education.psu.edu/geog128/node/719

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1. Traditional Society
- this stage is characterized by a subsistent, agricultural based economy, with intensive
labor and low levels of trading, and a population that does not have a scientific
perspective on the world and technology.

2. Preconditions to Take-off
- here, a society begins to develop manufacturing, and a more national/international,
as opposed to regional, outlook.
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3. Take-off
- Rostow describes this stage as a short period of intensive growth, in which
industrialization begins to occur, and workers and institutions become concentrated
around a new industry.

4. Drive to Maturity
- this stage takes place over a long period of time, as standards of living rise, use of
technology increases, and the national economy grows and diversifies.
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5. Age of High Mass Consumption

At the time of writing, Rostow believed that Western countries, most notably the
United States, occupied this last "developed" stage. Here, a country's economy
flourishes in a capitalist system, characterized by mass production and consumerism.

Some criticisms:
1. The model assumes development in the U.S. and Europe can be copied elsewhere.

2. Ignores a lot of geography and history, such as the impact of colonization on

economic development.
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3.5 Vicious Circle Theory

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Vicious Circle Theory

The vicious circle theory indicates that poverty perpetuates itself in mutually
reinforcing vicious circles on both the supply and demand sides.

Supply Side
Because incomes are low, consumption cannot be diverted to saving for capital
formation. Lack of capital results in low productivity per person, which perpetuates
low levels of income. Thus, the circle is complete. A country is poor because it was
previously too poor to save and invest.
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As Jeffrey Sachs (2005:56) explains the poverty trap: “Poverty itself [is the] cause of
economic stagnation.”

As countries grow richer, they save more, creating a virtuous circle in which high
savings rates lead to faster growth (Edwards 1995; Economist 1995b:72; World Bank
2003i:218–220).
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Demand Side
Because incomes are low, market size (for consumer goods such as shoes, electric
bulbs, and textiles) is too small to encourage potential investors.

Lack of investment means low productivity and continued low income.

A country is poor because it was previously too poor to provide the market to
increase investment.
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3.6 The O-Ring Theory of

Economic Development
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The O-Ring Theory of Economic Development

Michael Kremer (1993) uses the 1986 space shuttle
“Challenger” as a metaphor for coordinating production
in “The O-Ring Theory of Economic Development.”

The Challenger had thousands of components, but it

Exploded because the temperature at which it was
launched was so low that one component, the O-rings,
malfunctioned.

Image source: https://en.wikipedia.org/wiki/Michael_Kremer

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In a similar fashion, Kremer proposes a production function in which “production

consists of many tasks, [either simultaneous or sequential], all of which must be
successfully completed for the product to have full value”.

This function describes production processes subject to mistakes in any of several

tasks. You cannot substitute quantity for quality.

Highly skilled workers who make few mistakes will be matched together, with wages
and output rising steeply with skill.
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Rich countries specialize in complicated products, such as aircraft, whereas poor

countries produce simpler goods, such as textiles and coffee.

Kremer thinks the O-ring theory can explain why rich countries specialize in more
complicated products, have larger firms, and have astonishingly higher worker
productivity and average incomes than poor countries.
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3.7 The Lewis-Fie-Ranis

Model
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The Lewis-Fie-Ranis Model

This theory explains how economic growth gets started in a less-developed country
with a traditional agricultural sector and an industrial capitalist sector.

The source of capital in the industrial sector is profits from the low wages paid an
unlimited supply of surplus labor from traditional agriculture.

Economic growth occurs because of the increase in the size of the industrial sector,
which accumulates capital, relative to the subsistence agricultural sectors, which
amasses no capital at all.
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The Lewis Model

Urban industrialists increase their labor supply by attracting workers from agriculture
who migrate to urban areas when wages there exceed rural agricultural wages.

Sir William Arthur Lewis elaborates on this, in his explanation of labor transfer from
agriculture to industry in a newly industrializing country.

Lewis believes in zero (or negligible) marginal productivity of labor in subsistence

agriculture, a sector virtually without capital and technological progress.
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An unlimited supply of labor available to the

industrial sector facilitates capital accumulation
and economic growth.
ws = subsistence wage
wk = capitalists wage
MRPL = marginal revenue productivity of labor
SLK = labor supply curve

Lewis assumes that the capitalist saves the entire surplus (profits, interest, and rent)
and the worker saves nothing.
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Furthermore, he suggests that all the surplus is

reinvested, increasing the amount of capital per worker
and thus the marginal product of labor to MRPL2 , so
that more labor QL2 can be hired at wage rate wk.

This process enlarges the surplus, adds to capital

formation, raises labor’s marginal productivity,
increases the labor hired, enlarges the surplus, and
so on, through the cycle until all surplus labor is absorbed into the industrial sector.
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Beyond the point QL3 , the labor supply

curve (SLk) is upward-sloping and additional
laborers can be attracted only with a higher wage.
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The Fei–Ranis Modification

John Fei and Gustav Ranis, in their modification of the Lewis model, opposed that the
agricultural sector must grow, through technological progress, for output to grow
as fast as population; technical change increases output per hectare to compensate
for the increase in labor per land, which is a fixed resource.

They recognizes the presence of a dual economy comprising both the modern
(industrial sector) and the primitive (agriculture) sector.
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3.8 Dependency Theory

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Dependency Theory
Celso Furtado, a Brazilian economist and from the
U.N. Economic Committee for Latin America.

According to him, since the 18th century, global

changes in demand resulted in a new international
division of labor in which the peripheral countries
of Asia, Africa, and Latin America specialized in
primary products in an area controlled by foreigners while importing consumer goods
that were the fruits of technical progress in the central countries of the West.
Image source: https://en.wikipedia.org/wiki/Michael_Kremer
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The increased productivity and new consumption patterns in peripheral countries

benefited a small ruling class and its allies, who cooperated with the DCs to achieve
modernization.

The result is “peripheral capitalism”, a capitalism unable to generate innovations and

dependent for transformation upon decisions from the outside.

Image source: https://prabook.com/web/celso.furtado/3772201#gallery

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3.9 Solow’s Neoclassical

Growth Theory
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Solow’s Neoclassical Growth Theory

The MIT economist Robert Solow won a Nobel
Prize for the formulation of this theory.

Solow stressed the importance of savings and

capital formation for economic development,
and for empirical measures of sources of growth
and allowed changes in wage and interest rates,
substitutions of labor and capital for each other, variable factor proportions, and
flexible factor prices.
Image source: https://en.wikipedia.org/wiki/Michael_Kremer
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He showed that growth need not be unstable, because, as the labor force outgrew
capital, wages would fall relative to the interest rate, or if capital outgrew labor, wages
would rise.

Solow used the following Cobb–Douglas production function, written in the 1920s
by the mathematician Charles Cobb and the economist Paul Douglas, to distinguish
among the sources of growth – labor quantity and quality, capital, and technology.
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The equation is:

where Y is output or income, T the level of technology, K capital, and L labor

The parameter and exponent α is (ΔY/Y)/(ΔK/K), the elasticity (responsiveness) of

output with respect to capital (holding labor constant). (The symbol Δ means
increment in, so that, for example, ΔY/Y is the rate of growth of output and ΔK/K the
rate of growth of capital.) The parameter β is (ΔY/Y)/(ΔL/L), the elasticity of output
with respect to labor (holding capital constant).
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3.10 The New Growth

Theory
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The New (Endogenous) Growth Theory

The University of Chicago’s Robert Lucas finds that international wage differences
and migration are difficult to reconcile with neoclassical theory.

If the same technology were available globally, skilled people embodying human
capital would not move from LDCs, where human capital is scarce, to DCs, where
human capital is abundant, as these people do now.

Nor would a given worker be able to earn a higher wage after moving from the
Philippines to the United States
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New growth theorists think their model is closer to the realities of international flows
of people and capital than the neoclassical model.

Paul Romer, a University of California-Berkeley economist, believes that if technology

is endogenous (explained within the model), economists can explain growth where
the neoclassical model fails.

For new growth theorists such as Romer, innovation or technical change, the
embodiment in production of some new idea or invention that enhances capital and
labor productivity, is the engine of growth.
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When the level of technology is allowed to vary, you can explain more of growth,
as DCs have higher level than LDCs. Variable technology means that the speed of
convergence between DCs and LDCs is determined primarily by the rate of diffusion
of knowledge.

The endogenous theorists, whose message is continuous technological innovation, are

the strongest solution to the growth-limiting factors.
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References:
Todaro, M. P., Smith, S. C. (2012). Economic Development 11th Edition). Addison-Wesley
Nafziger, E. W. (2006). Economic Development 4th Edition. Cambridge University Press
https://corporatefinanceinstitute.com/resources/knowledge/economics/theories-of-growth/
https://www.e-education.psu.edu/geog128/node/719
 THANK YOU!
Ian Dave B. Custodio, LPT, MSc
Part-time Instructor
Western Leyte College
E-mail: iandave.custodio@wlcormoc.edu.ph
Website: iandavecustodio.github.io
Telephone (Office): (053) 563 7064 local 1121
Western Leyte College
College of Accountancy and Business
A. Bonifacio St., Ormoc City, Leyte
E-mail: info@wlcormoc.edu.ph
Website: wlcormoc.edu.ph
Telephone: (053) 561 5310 / 255-8549