Unit Four: Theories of Economic Development

Theories of Economic Development

4.1. The Classical Theory
4.2. The Marxian Theory
4.3. The Keynesian Theory
4.4 Lewis Theory of Unlimited Supplies
of Labor
4.5 Balanced Vs Unbalanced Growth
Theory
4.6 Dualistic Theories
 4.1 The Classical Theory

What is the 'Classical Growth Theory?

 The classical growth theory is the theory on economic growth

that argues economic growth will end because of an

increasing population and limited resources.

 Classical Growth Theory economists believed that

temporary increases in real GDP per person would

cause a population explosion that would

consequently decrease real GDP.

 Adam Smith and Ricardo Theories.

Adam Smith's Theory

 Adam Smith was an important Scottish political philosopher and economist
whose famous work Wealth of Nation (1776) set the tone for work
on politics and economics for many people even through today.

 He was primarily concerned the problems of economic development.

 His fundamental argument was regarded every individuals

should be allowed to pursue their own private

economic interests as much as possible.

 Every individual will seek to maximize his own

wealth and all individual will maximize aggregate

wealth

 Smith called this the “invisible hand” of the market – although

everyone is acting in their own self-interest, they are led to achieve the goal
of all as if by an invisible hand of economic forces.
 This “invisible hands” the automatic equilibrating mechanizing
of the perfect competitive market tends to maximizing national
wealth.
 He opposed to government intervention in industry, commerce
and advocated the policy of laissez faire in economic affaires

 Therefore, outside interference will inevitably lead to disaster.

This became known as laissez faire economic
policy.
 Smith also emphasized the capital accumulation, which
must precede the introduction of division of labor (the degree of
labor specialization).

 This capital accumulation as a necessary condition for economic

development.

 So the problem of economic development was largely the ability

people to saving more and more invest in the country.

 Because the rate of investment was determining by the rate of saving and the

rate of capital accumulation was determining by the rate of investment.

i.e, Capital
saving investment
accumulation

 Agents of Economic Growth in Smith

 According to Smith, farmers, producers and businessmen

are the agents of economic progress.

 The capital accumulation and economic development take place due to the
emergence of agents of economic progress.
 According to Smith, the process of growth is cumulative when there is

prosperity as a result of progress in agriculture, manufacturing, industries

and commerce
 It leads to capital accumulation, technical progress, increase in population,

and expansion of markets, division of labor and rise in profits continuously.

 All this happens in Smith’s progressive state.

 But this progressive state of Smith is not an endless. which is leads

to a stationary state.

 Because the scarcity of natural resources that

finally stops growth.

 In such a state the competition for employment would reduce wages

to the subsistence level and competition among business men would

bring profits as low as possible.
 Once profits fall, Investment also starts declining and in this way the end

result of capitalism is the stationary state.

 All these happen , capital accumulation stops: population become stationary;

profits are minimum ; wages are subsistence level ; there is no change in per
capital income and production and the economy reaches the state of
stagnation.
 The Ricardian Theory
 David Ricardo was another of the great classical pessimists.

 He was a self made millionaire land owner who argued vehemently/ forceful

against the interests of landowners.

 In 1817, he published his principles of political economy and

taxation, in which he predicted that capitalist’s economies, would end

up in a stationary state, with no growth, also owing to diminishing returns

in agriculture.

 He recognized by putting forth(forward) economic theories that

contradicted the interest of landowners.

 Assumption of the Ricardo theory
 The Ricardian theory is based on the following assumptions:

1. That all land is used for the production of corn and the
working forces in agriculture help in determine distribution in industry.

2. The law of diminishing returns operates on land.

3. The supply of land is fixed.

4. The demand of corn is perfectly inelastic.

5. That labor and capital are variable inputs.

6. The state of technical knowledge is given.

7. That all workers are paid a subsistence wages.

8. The supply price of labour is given and constant.

9. The demand for labor depends upon the
accumulation of capital and that both demand and supply price
are independent of the marginal productivity of labor.
10. There is perfect competition.
11. That capital accumulation results from profit.

 Given these assumptions, the Ricardian theory is based on the interrelations

of three groups in the economy.
 They are landlords, capitalists, and labourers, among who

the entire produce of land is distributed, as, rent, profits and wages
respectively.
 Ricardo was noisy critic of laws which favored landowners, most notably so
called “Corn Laws” and international borders.

 Ricardo thought of the economy as one big farm in which food (corn) and
manufactures are consumed in fixed proportions, so that corn can be used as
the unit of account.

 Ricardo never forward any theory of development. But, he simply discussed

the theory of distribution.
In Ricardo's model, like Smith's, growth and development is a function of
capital accumulation, and capital accumulation depends on reinvested profits.
Process of capital accumulation:
According to Ricardo, capital accumulation is the outcome of profit
because profit leads to saving of wealth which is
used for capital formation.

 Capital accumulation depends on two factors: First, the capacity

to save, and second they will to save and the
capacity to save is more important in capital accumulation.

This depends upon the surplus out of total output after meeting the cost of
workers subsistence.
 These larger of the output surplus, the capacity to save will be larger.

 In reality, profit depends on wages, wages on the price of corn

and the price of corn depends on the fertility of the marginal

land.

 In this way, there is an inverse relation between profits and wages,

and wages rise or fall in keeping with the price of corn.

 When there are improvements in agriculture, the productive power of land

increases this results in the fall in the price of corn.

 As a result, the subsistence wage also falls, but profits

increase and there is more capital accumulation.

 This will increase the demand for labour and the wage rate will rise.

 This, in turn, will increase population and the demand for corn and

its price.

 Thus wages will rise and profits decline.

 However, profits are squeezed between subsistence wages and the

payment of rent to land lords.

 which increases as the price of food rises owing to diminishing returns

to land and rising marginal costs.

 Increase in wages:

 In the Ricardian system wages play an active role in determining income

between capital and labour.

 The wage rate increases when the prices of commodities forming the

subsistence of the workers increase.

 The commodities consumed by workers are primarily agricultural

products.

 As the demand for population and food increases, less fertile land is

brought under cultivation.

 For this purpose, to produce a unit of the product more labourers are

required.
 At that time the demand for labour starts rising, which, raises wages.

 Moreover, to match the increasing cost of subsistence, money-wages will

also continue to rise.

 Thus wages would rise with the increase in the price of corn and then

profits would decline.

 In such a situation, rent also increases which absorbs the rise in the price of

corn.

 Since wages also increases, the ratio of capitalist’s profits declines.

 Free trade:

 Ricardo is in favour of free trade, free trade is an important factor

for economic development of the country.

 The profit rate can be saved from declining by importing corn.

 The capital accumulation will, therefore, continue to be high.

 In this way, the resources of the world can be used more efficiently through

foreign trade.

 But the import of corn leads to fall in the demand for labour which

deteriorates the economic condition of labourers.

 On the other hand, land-lords and capitalists do not think it fit to import

cheap corn from foreign countries, as a result their profits decline.

 This is but natural, because with the application of the law of

diminishing returns on land and increase in population, the price of corn

and wages increase the profit rate declines.
 The Ricardo’s Critical Appraisal
 Ricardo was the modern economists and his ideas on economic growth
have been adopted. They are as follows:
1. Ricardo emphasized the agricultural development in economic growth,
because industrial development depends on it.
2. Ricardo advocated the increase in the profit rate in economic
development for capital accumulation depends on it.
3. Like modern economists, His theory underlines the importance of saving
for higher capital accumulation.
4. Foreign trade in improving the economic condition of the economy
because it leads to the maximum utilization of resources and increase in
income.
 Weaknesses Of Ricardo theory
1. Neglects the impact of technology:

 Ricardo under-estimated the potentialities of technological progress in

counteracting diminishing returns of land.
2. Wrong notion of the stationary state:
 The Ricardian view that the economy reaches the stationary
state automatically is baseless because no economy attains the stationary
state in which profits are increasing, production and capital accumulation is taking
place.
3. Impracticable Laissez-faire policy:
 In reality, there is no economy which is free from governmental interference and in
which perfect competition prevails
4. Neglects institutional factors:
 He was neglects the role of institutional factors, But they are crucial in

economic development and cannot be overlooked.

5. Distribution rather than growth theory:

 According to Ricardian theory is not a growth theory but it is the theory of distribution

which determines the share of workers, landlords and capitalists.

 Ricardo failed to present a functional theory of distribution because he did not determine
the share of each factor separately.
6. Land also produces goods other than corn:
 Ricardo believed that only one product corn is produced on land. But this

is an outdated notion because land produces a variety of products other

than corn.

7. Capital and labour not fixed co-efficient:

 The Ricardian assumption that capital and labour are fixed co-efficients of

production is not correct.

 This assumption is invalid because labour and capital are independent

variables.
Question1: According to the Classical Theory of economic development, which of the
following is the primary driver of economic growth?
A) Government spending
B) Consumer spending
C) Accumulation of capital
D) Foreign aid

Question2: Who are the key proponents of the Classical Theory of economic development?
A) John Maynard Keynes
B) Karl Marx
C) Adam Smith, David Ricardo, and Thomas Malthus
D) Milton Friedman

Question3: In the Classical Theory, what role does the government play in economic
development?
A) Active intervention in the economy
B) Limited intervention, emphasizing free markets
C) Central planning of all economic activities
D) Providing subsidies to all industries
Question4: According to the Classical Theory, what drives
technological progress and economic growth?
A) Government investment in research and development
B) Pursuit of profit, competition, and division of labor
C) Consumer demand for advanced technology
D) International technology transfer agreements

Question5: What does the Classical Theory suggest about the

distribution of income in an economy?
A) It is determined solely by government policies
B) It is mainly influenced by consumer preferences
C) It is determined by the productivity of labor and supply
and demand in factor markets
D) It is irrelevant to economic development
4.2 The Marxian Theory
or
 Generally,
 Kar max was the founder of scientific socialism

 The central point in Maxism emphasis on the historical evolution of

social, political and economic institutions

 Capitalist institutions should be regarded as a product of the

productive power of the society.

 As the productive power of society develop, the existing economic and

political institutions should change.

 They outlive their usefulness and they must be replace by another set of

institutions appropriate to the higher stage of economic development

 4.3 The Keynesian Theory
Keynesians believe that, because prices are somewhat rigid,
fluctuations in any component of spending—consumption,
investment, or government expenditures—cause output to change.
If government spending increases, for example, and all other
spending components remain constant, then output will increase.
Keynesian economics is a theory that says the government should
increase demand to boost growth.
Keynesians believe consumer demand is the primary driving
force in an economy.
As a result, the theory supports the expansionary fiscal policy.
Government spending is the most important economic activity
 Additional points the Keynesian Theory focus on
the following

1. Physical development (roads and dams) and

Economic Growth
2. Physical and Mental Change or Social
Development
3. Human Resource Development vs. Social
and Economic Change
4. Proposed a Mixed Economy- public and
private
 4.4 The Lewis' Theory of Unlimited Supplies of
Labor
Lewis has developed a very systematic theory of economic
development with unlimited supplies of labor
He focused on the structural transformation of a subsistence
economy because Which is structural –change theory approach
Like other classical economists he believes in the existence of an
unlimited supply of labor at a subsistence wage
Economic development takes place when capital accumulates as
a result of the withdrawal of surplus labor from the
subsistence sector to the capitalist sector.
 The capitalist sector is that part of the economy which uses

reproducible capital and pays capitalists for the use there of.

 It employs labor for wages in mines, factories, and plantations

for earning profits.

 However, the subsistence sector is that part of the economy

which does not use reproducible capital.

 In this sector, output per head is lower than in the capitalist

sector
 Together with Adam Smith and other classical economists, Lewis sees
the basic problem as low savings.
 The key to development is to be found in mechanisms which

dramatically increase the savings rate.

 Increased savings, in a capitalist economy, come mainly if not entirely

from savings out of the profits of the capitalists.

 The reason why savings are low in an underdeveloped economy that

capitalists’ profits are low relative to national income.

 As the capitalist sector expands, profits grow relatively, and an

increasing proportion of national income is reinvested

 4.4.1 Lewis’s basic model

 Lewis’s basic model may be set out as follows. First, let us assume two

sectors in the economy.

 One, a capitalist or modern sector, uses physical capital

owned by the capitalists and employs wage-labor for profit.

 The other sector is an overpopulated traditional or

subsistence sector.

 Here the second sector the organization of production is small scale,

with family activity being the norm.

 Some of the labor in the traditional sector may be characterized

as “surplus labor,” in the sense that it can be withdrawn from

the sector without any noticeable loss of output.

 This is because, in this sector, productivity at the margin is very

low and may even be zero or negative.

The primary focus of the model is on both the process of labor
transfer and the growth of output and employment in the
modern sector.

 (The modern sector could include modern agriculture, but we

will call the sector “industrial” as a shorthand).

Both labor transfer and modern-sector employment growth are

brought about by output expansion in that sector.
 Capitalists will not have to continually
raise wages to attract increasing amounts
of labor into the modern sector.

 One reason for this will be the existence of disguised

unemployment in the traditional sector where the marginal

product is “negligible, zero or even negative”
 4.4.2 Criticisms of the model

1.The model implicitly assumes that the rate of labor transfer and

employment creation in the modern sector is proportional to

the rate of modern sector capital accumulation

2. Implicit in the model is the notion that there is surplus labor

in rural areas and full employment in urban
areas.

3. nominal and real urban wages in the capitalist sector of many Third
World countries appear to be able to rise rapidly, even when there is
substantial unemployment
4. The model presumes the existence of entrepreneurs who will act
in the way specified.

5. Marginal productivity of labor in the rural sector is not zero or

negligible in LDCs as argued by the theory. if it was so, the
subsistent wage would also be zero.

6. Higher capitalist wage will not necessarily lead to the movement

of surplus labor from the subsistent sector to the capitalist sector.
 4.5 Balanced vs Unbalanced Growth Theories

1. Balanced growth

 Balanced growth requires a balance between different consumer durable

good industries and capital good industries.

 It also implies a balance between industry and agriculture, and between

the domestic and export sector.

 Further it refers to the balance between social and economic overheads

and directly productive investments

 In short, the theory states that there should be a

simultaneous and harmonious development of

different sectors of the economy so that all sectors
grow together.

 This doctrine requires a balance between different

sectors of the economy during the process of

economic growth.

 There should be a proper balance between investment in agriculture

and industry, which are complementary sectors.

An increase in the industrial sector’s output
requires an expansion of agricultural output if
employment increases in the industrial sector, it
will lead to an increase in the demand for food.

 This necessitates the rise in food supplies.

Similarly supplies of raw materials should also rise

with the expansion of the industrial sector.

In short, the agricultural sector must also develop

along with the industrial sector’s development.
 There must also be a balance between the domestic and foreign sector.

Export revenue is an important source for financing

development.

 As production and employment increase, the domestic sector

requires increasing imports of necessary materials (raw materials

and machineries).

To pay for these rising imports and to allow exports to finance

development, the country must expand its foreign sector along

with the expansion in the domestic sector.
 Criticism of the balanced growth doctrine

1. Rise in costs

 Simultaneous establishment of a number of industries is likely to raise

money and real cost of production.

2.Demand side problems

 When the new industries are established, the demand for the products of

existing firms will decrease.

 The demand for factors of production, on the other hand, rises causing a

rise in price of inputs (factors).

 This makes the industries unprofitable.

3. Doesn’t consider the capacities of poor
nations( shortage of resources)

The doctrine doesn’t consider the capacities of poor nations.

The resources (human and physical) those are required for

simultaneous development of multiple sectors is lacking in

developing countries.

When investments are undertaken in all sectors simultaneously, the

demand for factors would be competitive but the supply of factors

would be inelastic in poor nations.
4. Scarcities and shortages encourage growth

 Scarcities and bottle necks provide the stimulus to inventions and inventions

in turn created new scarcities and bottlenecks.

 Some economists argue that had the world depended on balanced

development, it would have reduced or eliminated the incentives for

discoveries.

5. The concept of balanced growth is only applicable

to developed or rich nations
 2. Unbalanced growth

 This theory is the direct opposite of the doctrine of the balanced

growth.
 It argues investment should be made in selected
sectors rather than simultaneous investment in all
sectors.
 No poor country owns capital and other resources in such quantities as to
enable it invest simultaneously in all sectors.
 Hence, investment should be made in a few selected sectors or industries for
their rapid development, and the economies arising from them can be
utilized for the development of other sectors.
 Thus the economy moves gradually from the path of unbalanced

growth to balanced growth.

 The process of unbalancing the economy to bring about

development can be undertaken through investing in social

overhead capital or in directly productive activities.

Unbalancing the economy with social overhead capital

 It comprises those basic services without which primary,

secondary and tertiary productive activities cannot function.

It includes investment on education, public health, communication,
transportation and conventional public utilities like light, water, power,
irrigation, drainage schemes etc.

Large investments in social overhead capital will latter encourage

investment in directly productive activities. E.g. cheaper supply of
electric power may encourage establishment of industries.

 The objective is to unbalance the economy so that subsequent (the

following time) investments are stimulated.
Unbalancing the economy with directly productive activities

 The government may invest in directly productive activities instead of

investing in social overheads.

 If direct productive investment is undertaken first, the shortage of social

overhead facilities is likely to raise production costs.

 In course of time, political pressures might stimulate investment in social

overheads.

 Investment sequences are generated by profit expectations and political

pressures.


 Limitations (criticisms) of the unbalanced growth
doctrine
1.Too much emphasis on investment decisions
 Poor countries not only need investment decisions but also administrative,
managerial and policy decisions. The theory lays too much emphasis on
investment decisions as compared to other important decisions required
for development
2. lack of basic facilities
 There may be difficulties in having technical personnel, raw materials, and
basic facilities like power, transport, markets for products etc.
3.lack of factor mobility
 In LDCs it is difficult to shift resources from one sector to another.
 4.6. The Dualistic-Development Thesis:
 It is the explicit in International Dependence Revolution (IDR growth

theory).

 Dualism is a concept widely discussed in development economics, which

represents the existence and persistence of increasing divergences between

rich and poor nations and rich and poor peoples at all levels.

 Specifically, although research continues, the traditional concept of

dualism embraces four key arguments. These are:

1. Different sets of conditions, of which some are “superior” and
others “inferior,” can coexist in a given space.

 Examples of this element of dualism include Lewis’s notion of

the:

coexistence of modern and traditional methods of

production in urban and rural sectors respectively.

the coexistence of wealthy, highly educated elites with masses of

illiterate poor people.
2. This coexistence is chronic and not merely transitional.

 It is not due to a temporary phenomenon, in which case time could

eliminate the discrepancy between superior and inferior elements.

3. Not only do the degrees of superiority or inferiority fail

to show any signs of diminishing, but they even have an
inherent tendency to increase.

 For example, the productivity gap between workers in developed countries

and their counterparts in most developing countries seems to widen with

each passing year.
4. The interrelations between the superior and inferior elements
are such that the existence of the superior elements does little
or nothing to pull up the inferior element, let alone “trickle
down” to it.

 In fact, it may actually serve to push it down—to “develop its

underdevelopment.”
3. Development with unlimited supplies of labour
hypothesis was originally formulated by
A. Gustav Ranis
B. J. Schumpeter
C.R. Nurkse
D. B.W. A. Lewis
Thank you!!