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Development Economics - The Minimum

Part 1 - Characteristics of developing countries

The difference between growth and development
You need to know definitions of economic growth and economic development. You also need to know the components of the HDI.

Common characteristics of developing countries

1. Low standards of living, characterised by low incomes (high poverty levels), inequality, poor health, and inadequate education. Individual 2. Low levels of productivity (output per person). Individual affects Economy Main causes are: low education standards low levels of health amongst workers lack of investment in physical capital lack of access to technology 3. High rates of population growth and dependency burdens. Consequences/Costs for Government The crude birth rate is the annual number of live births per 1,000 of the population. Developing countries tend to have crude birth rates that are more than double, on average, the rates in developed countries. The dependency ratio is the percentage of those who are non-productive, usually those who are under 15 and over 64, expressed as a percentage of those of working age, usually 15 to 64. The high crude birth rates mean that there are a lot of young people, under the age of 15, in developing countries. Developed countries also have high numbers of the population over the age of 64, who also need to be supported by the work force. 4. High and rising levels of unemployment and underemployment. Factor of production Unemployment figures in developing countries are worrying enough, there are three more groups that need to be considered: Those who have been unemployed for so long that they have given up searching for a job and no longer appear as unemployed. The hidden unemployed, those who work for a few hours in the day on a family farm or in a family business or trade of some sort, and so do not appear as unemployed. The underemployed - those who would like full time work, but are only able to get part time employment, often on an informal basis. 5. Substantial dependence on agricultural production and primary product exports. Producers 1

However, we should be aware that primary product prices, in many cases have been increasing and so the Terms of Trade in many developing countries has been improving.

6. Prevalence of imperfect markets and limited information. Markets The lack of: a functioning banking system a developed legal system adequate infrastructure, especially in terms of transport routes of all types accurate information systems for both producers and consumers 7. Dominance, dependence, and vulnerability in international relations. Economy

Diversity among developing countries

Developing countries display notable diversity in a number of areas: 1. Resource endowment Endowment in terms of physical resources can vary immensely between developing countries. Angola possesses oil and diamonds, and yet is still very much a developing country. Chad had been considered a country that lacked physical resources, but the discovery of oil and subsequent production since 2003, may make a large difference to the country. Historical background A large proportion of developing countries were once colonies of developed countries. However, the extent to which this has affected these countries varies greatly. Geographic and demographic factors Developing countries differ hugely in terms of geographical size and also in terms of population size. Some developing countries are truly huge, such as China, Brazil, India and the Democratic Republic of the Congo, whereas others are very small in terms of land mass, such as Swaziland and Jamaica. Ethnic and religious breakdown Developing countries have a wide range of ethnic and religious diversity. High levels of ethnic and religious diversity within a country make it more likely that there will be political unrest and internal conflict. 5. The structure of industry It is widely assumed that all developing countries depend upon the production and exporting of primary products. Developing countries such as Ethiopia and Uganda may be typical of many, in terms of primary product export dependence, but other countries, such as Bangladesh and Nepal, are exporters of manufactured products, and others, such as Cape Verde, and the Maldives, are actually mainly exporters of services, in the form of tourism. 6. Per capita income levels 2




There are marked differences in per capita income from developing country to developing country. 7. Political structure Developing countries have very different political structures from each other.

Part 2 - Sources and consequences of economic growth and economic development

Economic growth
We should remember the distinction between potential growth and actual growth. Potential growth occurs when there is an outward shift in the PPC and a rightward shift in the LRAS curve. This is a measure of supply potential and is what we will consider in this section.

Sources of economic growth

These may be identified under four simple headings: 1. Natural factors Anything that will increase the quantity and/or quality of a factor of production should lead to an increase in potential growth. 2. Human capital factors The quantity of human capital may be increased either by encouraging population growth, or by increasing immigration levels. However, the majority of developing countries would not be keen to increase population size and, even if they were, like Singapore, the process is very long term. Thus, most emphasis is put on improving the quality of the human capital. 3. Physical capital and technological factors Economic growth may be achieved by improving the quantity and/or quality of physical capital. Physical capital includes such things as factory buildings, machinery, shops, offices, and motor vehicles. [Social capital is such items as schools, roads, hospitals, and houses.] We identify two concepts here: Capital widening this exists when extra capital is used with an increased amount of labour, but the ratio of capital per worker does not change. In this case, total production will rise, but productivity (output per worker) is likely to remain unchanged. Capital deepening this exists when there is an increase in the amount of capital for each worker. This often means that there have been improvements in technology. Capital deepening will usually lead to improvements in labour productivity as well as increases in total production. 4. Institutional factors A prerequisite for meaningful economic growth is the existence of certain institutional factors. These are factors such as an adequate banking system, a structured legal system, a good education system, reasonable infrastructure, political stability, and good 3

international relationships. Some of these factors are also sources of economic development, as we will see later in this chapter.

Consequences of economic growth

Bearing in mind that consequences may be positive or negative, we should consider what might be the outcomes of higher levels of economic growth: 1. 2. 3. 4. 5. Higher incomes Improved economic indicators of welfare Higher government revenues Creation of inequality Negative externalities and lack of sustainability

Sources of economic development

Some factors are not only sources of economic growth, but are also sources of economic development: 1. 2. 3. 4. Education Health care Infrastructure Political stability

Part 3 - Barriers to economic growth and economic development

It is widely agreed that there are many barriers to growth and development that hold back developing countries. It is perhaps easiest to understand them if they are separated into different categories. However, you should not lose sight of the fact that many of the barriers, although in different categories, are in fact interconnected. You also need to be aware of the ways in which some barriers act as an obstacle to economic growth, some to economic development, and some to both.

Institutional and political barriers

Insufficient provision of education Insufficient health care systems Lack of infrastructure Weak institutional framework - the legal system and property rights The financial system Ineffective tax structure and formal and informal markets Political instability and corruption Unequal distribution of income


International trade barriers

Overdependence on primary products, adverse Terms of Trade and the consequences of a narrow range of exports Protectionism in international trade

3. International financial barriers

Indebtedness Monetary capital flight Human capital flight Non-convertible currencies

4. Social and cultural barriers

Certain cultures disapprove of discussing matters relating to sex, especially with the young. The role of women

5. Poverty trap/poverty cycles

Relative poverty, which is a comparative level of poverty. A person is said to be in relative poverty if they do not reach some specified level of income. For example, a poverty level of 50% of average earnings may be set in a country and anyone who earns less than this figure would be deemed to be relatively poor. Absolute poverty. The level for absolute poverty is measured in terms of the basic necessities for survival. It is the amount that a person needs to have in order to live. It is the level of income that is sufficient to buy items such as basic clothing, food and shelter. It enables us to make comparisons across the world. For this to be possible, however, we must use purchasing power parity (PPP) exchange rates. The World Bank uses an absolute poverty line of US$1 per day, calculated using PPP exchange 5

rates. If a person is below this level, then they are considered to be in absolute poverty. They have also issued figures for US$2 per day. A poverty trap is any linked combination of barriers to growth and development that forms a circle, thus self-perpetuating unless the circle can be broken. These traps may be illustrated by the use of a poverty cycle. Poverty cycles are also sometimes known as development traps.

Part 4 - Growth and development strategies

Growth Models
Harrod-Domar growth model In its simplest form, the model states that the rate of growth of GDP is determined by the national savings ratio and the ratio of capital to output in the economy. It can be stated as: Rate of growth of GDP = Savings ratio1 Capital/output ratio2

So, if the savings ratio in the country is 5% and the capital/output ratio is 2.5, then the country can grow at a rate of 2% per annum. If the model is correct, then we can say that the rate of growth of an economy may be increased by one of two things: Increasing the levels of saving in the economy

Reducing the capital/output ratio in the economy

Structural change/dual sector model The Lewis dual sector model attempts to explain how an underdeveloped economy moves from being a traditional agrarian economy, with a small manufacturing sector, to an economy where there is a more modern balance, with a larger manufacturing and service sector.

1 2

The marginal propensity to save. The expenditure on capital as a ratio of the output gained from capital. Thus, it may be that it is necessary to spend $2.5 on capital in order to increase the national output by $1. Thus the ratio would be 2.5:1.

Growth Strategies
Export-led growth is an outward-oriented growth strategy, based upon openness and increased international trade. Import substitution is more fully known as import substitution industrialisation (ISI). It may also be referred to as an inward-oriented strategy. It is a strategy that says that a developing country should, wherever possible, produce goods domestically, rather than import them. This should mean that the industries producing the goods domestically will be able to grow, as will the economy, and then will be able to be competitive on world markets in the future, as they gain from economies of scale. Obviously, it is the opposite of exportled growth and is not supported of by those economists who believe in the advantages of free trade based on comparative advantage. Foreign Direct Investment [FDI] FDI is long-term investment by private multinational corporations (MNCs) in countries overseas. FDI usually occurs in one of two ways. MNCs either build new plants or expand their existing facilities in foreign countries. MNCs are attracted to developing countries for a number of reasons: The countries may be rich in natural resources, such as oil and minerals. Some developing countries, such as Brazil, China and India, represent huge and growing markets. The costs of labour are much lower than in more developed countries. In many developing countries, government regulations are much less severe than those in developed countries. Possible advantages associated with FDI FDI helps to fill the savings gap and thus may lead to economic growth. MNCs will provide employment in the country and, in many cases, may also provide education and training. This may improve the skill levels of the work force and also the managerial capabilities. MNCs allow developing countries greater access to research and development, technology, and marketing expertise and these can enhance its industrialisation. Increased employment and earnings should have a multiplier effect on the host economy, stimulating growth. The host government should gain tax revenue from the profits of the MNC, which may then be used to gain more growth by investing in infrastructure, or to improve public services such as health and education to promote economic development. If MNCs buy existing companies in developing countries, then they are injecting foreign capital and increasing the aggregate demand. In some cases, MNCs may improve the infrastructure of the economy, both physical and financial, or they may act as a spur for governments to do so, in order to attract them. The existence of MNCs in a country will provide more choice for consumers and lower prices. They may be able to provide essential goods that are not available domestically. 8

MNC activities along with liberalised trade can lead to a more efficient allocation of world resources.

Possible disadvantages associated with FDI Although MNCs do provide employment, it is argued that they often bring in their own management teams, simply using inexpensive low skilled workers for basic production, and providing no education or training. This also limits the ability of host countries to acquire new technologies. In some cases, it is argued that MNCs have too much power, because of their size, and so gain large tax advantages, or even subsidies, reducing potential government income in developing countries. Along the same lines, it is argued that MNCs have too much power internationally. Their incomes and size allow them to exert too much influence on policy decisions taken in institutions such as the WTO. MNCs practise transfer pricing, where they sell goods and services from one division of the company to another division of the company in a separate country, in order to take advantage of different tax rates on corporate profits. In this way, developing countries, with low tax rates to encourage MNCs to invest, reap little tax reward, and developed countries also lose out on potential tax revenue. Given that approximately one-third of all international trade is made up of sales from one branch of a firm to another firm, this represents a potentially large loss of potential revenues to governments. It is argued that MNCs situate themselves in countries where legislation on pollution is not effective, and thus they are able to reduce their private costs while creating external costs. Whilst this is good for the MNC, it is obviously damaging for the environment of thehost country. In the same way, MNCs may set up in countries where labour laws are weak, or almost non-existent, allowing the exploitation of local workers in terms of both low wage levels and poor working conditions. It is argued that MNCs may enter a country in order to extract particular resources, such as metals or stones, and will then strip those resources and leave. There may be significant unrest as host country nationals see that the profits from their resources are being sent out of the country to foreigners. Economists have argued that MNCs may use capital-intensive production methods to make use of abundant natural resources. Obviously, this will not greatly improve levels of employment in the country. It is argued that the MNCs should use appropriate technology, where production methods are aligned to the resources available. Since developing countries usually have a large supply of cheap labour, the argument is that labour-intensive production methods would be more appropriate. In most cases, where MNCs buy domestic firms, the owners of the firms being bought are paid in shares (stocks) from the MNC. This means that it is likely that the actual money will never be used in the developing countrys economy. MNCs may repatriate their profits. This means that they transfer their profits out of the country back to the MNCs country of origin. Whilst most would agree that FDI is a positive factor for current economic growth, the main concerns relate to the possible negative effects of MNCs on sustainable economic development. The extent to which FDI is able to contribute to this development depends very much on the type of investment and the ability of the host country governments to 9

appropriately regulate the behaviour of the MNCs and to use the benefits of the investment to achieve development objectives.

Development strategies
Fairtrade organisations Fairtrade schemes are an attempt to ensure that producers of food, and some non-food, products in developing countries receive a fair deal when they are selling their products. If consumers are aware of the harsh and often unfair conditions facing the farmers, then perhaps they will be willing to buy from producers who pay a fair price to the farmers. Micro-finance In developing countries, poor people find it almost impossible to gain access to traditional banking and financial systems, since they lack assets to use as collateral, are often unemployed, and lack savings. If they can find a way to borrow money, it is often at exorbitant interest rates. There is however, a type of financial service that is geared specifically to the poor. This is known as Micro-finance and is the provision of financial services, such as small loans, savings accounts, insurance, and even services such as a cheque book. The provision of small loans to individuals who have no access to traditional sources is known as micro-credit. A key element of original micro-credit schemes is that they did not originate in the developed world, but rather had their beginnings in developing countries.


Part 5 - Aid and indebtedness

Aid, or foreign aid, is defined as any assistance that is given to a country that would not have been provided through normal market forces. Aid may be provided to developing countries for a number of reasons: To help people who have experienced some form of natural disaster or war. To help developing countries to achieve economic development. To create or strengthen political or strategic alliances. To fill the savings gap that exists in developing economies, and thus encourage investment. To improve the quality of the human resources in a developing country. To improve levels of technology. To fund specific development projects. Official aid, is aid that is organised by a government or an official government agency. Unofficial aid, which is organised by a non-government organisation (NGO), such as Oxfam.

Humanitarian aid
Humanitarian aid is aid given to alleviate short-term suffering and usually comes under the heading of grant aid, which is short-term aid provided as a gift and does not have to be repaid. The three main forms of grant aid are: Food aid the provision of food from donor countries or money to pay for food. It also includes money given for the transport, storage and distribution of food. Medical aid the provision of medical services and provisions from donor countries, as well as money to facilitate medical services. Emergency aid the provision of emergency supplies, including temporary shelters, such as tents, clothing, fuel, heating, and lighting. All of the above forms of grant aid may be classified as official aid or unofficial aid, depending upon their origin.

Development aid
Development aid is aid given in order to alleviate poverty in the long-run and the welfare of individuals. Development aid is often referred to specifically as Official Development Assistance (ODA). This is aid provided by governments on concessional terms; sometimes as simple donations. It may be provided by individual countries, through their official aid agencies, or through multilateral organisations, such as the many branches of the United Nations. Types of development aid Long-term loans These are loans that are usually repayable by the developing country, in foreign currency, over a period of ten to twenty years. The loans are known as concessional loans or soft loans, which are sometimes repayable in 11

foreign currency, sometimes in the local currency, and sometimes in a mixture of both. Obviously, the developing countries would prefer loans that are repayable in their own currency, since they would not then have to use valuable, and scarce, foreign currency. They tend to have very low rates of interest and to be repayable over a longer period of time than a standard commercial loan.. These loans may come via official aid or non-official aid. Tied aid This is grants or loans that are given to a developing country, but only on the condition that they use the funds to buy goods and services from the donor country. Project aid This is money given for a specific project in a country and is often given in the form of grant aid, which requires no repayment. The projects are often to improve infrastructure. One of the main suppliers of project aid to developing countries is the World Bank.

Most forms of development aid can be official or unofficial. In addition, there are two further ways of classifying official aid: Bilateral aid This is aid that is given directly from one country to another. Multilateral aid This is aid that is given by rich countries to international aid agencies, such as the World Bank Group International Bank for Reconstruction and Development, the United Nations Childrens Fund, and the International Monetary Fund. It is then up to the agencies to decide where the aid is most needed and will be most effectively used.

The World Bank Group

The World Bank Group is a collection of five individual organisations. The World Bank was established, following the Bretton Woods Agreements, in 1945. The main aims of the group are to provide aid and advice to developing countries, as well as reducing poverty levels and encouraging, and safeguarding, international investment. The overarching aim of the group is to promote economic development.

The International Monetary Fund (IMF)

The IMF was proposed at the Bretton Woods Agreements in 1944 and began financial dealings on 1st March 1947. The IMF is an organization of 184 countries, working to foster global monetary cooperation, secure financial stability, facilitate international trade, promote high employment and sustainable economic growth, and reduce poverty.

Concerns about aid

Much research suggests that there appears to be no significant correlation between the level of aid given to a developing country and the growth of GDP. There are a number of concerns associated with aid as a means of reducing poverty: The government in power may not necessarily have the welfare of the majority of the population at heart.


Aid received often goes to a small sector of the population. In many cases, these are relatively wealthy city dwellers. In cases where there is extreme corruption, aid often leaves the country almost as soon as it has come in. Aid is sometimes given for political reasons, rather than being given to countries where the need is greatest. Tied aid is not as effective as untied aid. The provision of tied aid has fallen in recent years and it has actually been made illegal in some countries. For example, the UK made tied aid illegal in June of 2002. Whilst the short-term provision of food aid may be essential, long-term provision of large quantities of food may force down domestic prices and make matters worse for domestic farmers. What would be better for farmers would be a reduction in the subsidies given to farmers in the richer countries. Continued dependency on aid may mean that there is little incentive to be innovative and that people develop a welfare mentality, where they feel that aid will always be there to help them. Some argue that aid is often focused on the modern sector, industrialisation, and may cause a greater gap in incomes and living standards between those in that sector and those in the traditional agricultural sector. Aid is often only available if the country agrees to adopt certain economic policies. It is argued that these policies might be more in the interest of the richer countries and multinational companies and not necessarily in the best interest of developing countries. There is a suggestion that people in developed countries are beginning to suffer from aid weariness. They are beginning to think that problems in their own economies may be more important than problems in other countries. This may start to reduce the flows of aid.

We must not forget that in the poorest countries, private investment is not an option, and aid may be the only hope. Wars, an illiterate and uneducated workforce, corruption and a lack of infrastructure mean that it is impossible to attract private investment. In these extreme cases, directly targeted aid, often from NGOs, may be the only viable option, if growth and development are to be achieved.

Non-Government Organisations
It is very difficult to generalise about NGOs as they are incredibly diverse in size, orientation, outlook, nationality, income and success. However, we can say that for the most part, the priority of NGOs is to promote economic development, humanitarian ideals and sustainable development. Their work might be to provide emergency relief in cases of disasters or to provide long term development assistance. Examples of international NGOs are Oxfam, CARE, Mercy Corps, Cafod, Greenpeace, Amnesty International, Global 2000 and Doctors Without Borders. There are essentially two main activities carried out by NGOs. They plan and implement specifically targeted projects in developing countries and they act as lobbyists to try to influence public policy in areas such as poverty-reduction, workers rights, human rights and the environment. 13

One of the major drawbacks to growth and development in developing countries is the level of debt repayments that developing countries have to make on money that was borrowed in the past. At the present time, many developing countries still have major problems with indebtedness. This has led to much international public debate about the importance of debt relief. Many argue that the debts of developing countries should be reduced or cancelled. One reason in favour of debt relief relates to debt servicing, the repayment of the original debt plus interest repayments. Some countries have only been able to afford to pay back interest, and not always all of it, so they have found that their debt has actually grown. For example, Nigeria borrowed $17 billion, has paid back $18 billion so far, and still owes $34 billion3. It has been argued that this escalation of the original debt is unfair.

Source: Make Poverty History, Geraldine Bedell, Penguin Books, 2005.


Part 6 - Market-led v interventionist growth strategies

Market-led strategies are policies that are designed to minimise the role of the government and to maximise the free operation of supply and demand in markets. Examples of this would be: export-led growth growth through FDI privatisation of national industries deregulation the Structural Adjustment Policies and Poverty Reduction Strategy Papers of the International Monetary Fund and the World Bank They are known by a number of names including free market policies, neo-classical policies, or neo-liberal policies. Interventionist strategies are policies involving an active role by the government and manipulation of the workings of the markets in the economy. Examples of this would be: import substitution protectionist trade policies exchange rate intervention regulations nationalisation of industries government involvement in export markets to promote certain industries and their products From the end of the Second World War, and for about the next thirty years, the main emphasis was government planning. However, there were no real examples of sustained growth and development from the countries involved, and also there were other problems that arose. Public sectors in these countries grew too large, leading to bureaucracy, over staffing, and inefficiency. This, together with growing political instability, also provided the opportunity for the growth of corrupt practices. Nationalised industries, of which there were many, tended to be inefficient and thus loss-making. They also led to hidden unemployment. Government spending tended to be excessive, leading to large budget deficits, and thus the need for borrowing and for increasing the money supply. The increases in the money supply tended to lead to high levels of inflation. Much of the expenditure was on large infrastructure projects that saw little success. In the 1980s, there was a movement towards more free market, supply side-oriented governments in developed countries and a change of direction in thinking on the best way to achieve growth and development in developing countries. 15

As well as the change in economic policies in major developed countries, there were a number of other factors that influenced this change of direction: Following the Third World Debt Crisis, there were many developing countries that needed to borrow money from the IMF in order to avoid defaulting on their loans. The IMF would only grant loans if the countries adopted Structural Adjustment Policies that, as we know, were very market based. The transition of the Soviet Union and its satellite states towards market based economies, which started in the late 1980s, had two effects. Firstly, it acted as a signal that planning was not a successful option in the quest for growth and development. Secondly, it removed financial support for a number of developing countries, which had been aligned with Eastern Bloc countries, forcing them to seek support elsewhere. The perceived success of the Asian Tigers such as Japan, Taiwan, Singapore, Hong Kong, and South Korea, who appeared to have adopted export-led growth and encouraged FDI, was influential in influencing thinking on the ways to achieve high levels of economic growth. Developing countries were encouraged to reduce the role of the government in their economies and to adopt a more outward looking approach to achieving growth. In general terms, this included: Freeing domestics markets, by eliminating price controls and subsidies, and increasing competition. Liberalising international trade, by eliminating trade restrictions, and encouraging FDI. Privatising nationalised industries. Reducing government expenditure in order to eliminate budget deficits. However, as we have moved into the new century, a number of concerns have been raised about the value of adopting a pure market-led approach: Infrastructure is unlikely to be created through a market-based approach and developing countries simply do not have sufficient infrastructure to adopt a free market approach. Thus, this requires planning for the future and government intervention. Although the more developed countries promote trade liberalisation, they themselves do not liberalise all their trade. Protectionism in developed countries makes it very difficult for the developing countries to compete on a fair basis. In recent years, lead by the larger developing countries such as Brazil and India, developing countries have been cooperating with each other to have more influence in trade negotiations. The success of the export-led Asian Tigers did not occur without government intervention. The governments in question were very interventionist in specific areas, especially in product markets that needed help and protection before they were able to export. They also were able to place great emphasis upon education and health care. Although a more free market approach may lead to economic growth in the long run, there are without doubt short run costs to the poorest people. In the short run, unemployment rises, as do the prices of essential products, and the provision of 16

public services also falls. Obviously, this will hit the poorest sector of the population more than any one else, causing greater income inequality. The adoption of free market strategies tends to concentrate attention and activities on the urban sectors of an economy and this tends to increase the divide between rural and urban areas, increasing the levels of poverty in rural areas and also leading to migration from rural areas to urban areas. This has created large area of slums on the edges of many major cities in developing countries.

In the end, it is clear that the solutions will lie in a combination of different approaches and that the combination will need to be tailored to suit the needs of each individual country. Adopting a one size fits all policy will not be effective, as the IMF discovered with SAPs in the 1980s. As a brief conclusion, we try to summarise some of the conditions that economists believe would be necessary for both economic growth and economic development to be achieved in developing countries. Trade justice so that the developing countries are trading on a fair basis with the developed countries, not hampered by protectionist policies. Debt relief to release funds that may be invested in physical and human capital. The free working of domestic markets, but only once the markets have achieved a competitive size and have sufficient support in terms of infrastructure, quality of the labour force, and technological and managerial expertise. The encouragement of political stability and good governance and the elimination of corruption. Effective, targeted, aid that leads to pro-poor growth so that the aid given is directed at policies that will encourage economic growth that leads to a fall in poverty.