Classic Theories of Economic

Development
 Part I
• Four Approaches
• Linear-Stages-of-Growth Models
• Structural-Change Models
• International Dependence Revolution
• Market Fundamentalism
 Four Approaches
• Four major and often competing development
theories, all trying to explain how and why
development does or does not occur.
• Newer models often draw on various aspects of
these classical theories.
• In the 1950’s and 1960’s, linear-stages-of-
growth models were popular. They described the
process of development as a series of
successive stages.
• These models were replaced in the 1970’s by
Structural Change and International
Dependence models.
• Structural change models emphasized the
internal process of structural changes that a
developing country must go through, while
international dependence models viewed
underdevelopment in terms of international and
domestic power relationships, institutional and
structural rigidities and the resulting proliferation
of dual economies and dual societies both within
and among nations of the world.
• In the 1980’s and 1990’s the neoclassical
counterrevolution focused on the
beneficial role of free markets, open
economies and the privatization of public
enterprises and suggested that the failure
of some economies to develop is a result
of too much government intervention and
regulation.
 Linear-Stages-of-Growth Models
– Rostow’s Stages of Growth
– Harrod-Domar’s Growth Model
• The thinking here was that the developing
countries could learn a lot from the historical
growth experience of the now developed
countries in transforming their economies from
poor agrarian societies to modern industrial
giants.
• Emphasized the role of accelerated capital
accumulation.
 Rostow’s Stages of Growth
• Rostow argued that economic development can be
described in terms of a series of steps through which
all countries must proceed:
1. The Traditional Society
2. The Pre-conditions for take-off into self-sustaining growth
3. The Take-off
4. The Drive to Maturity
5. The Age of High Mass Consumption
• Advanced nations were considered well beyond the
take-off stage while underdeveloped nations were
seen as still in the traditional or pre-conditions stages.
• Emphasized the need for the mobilization of domestic
and foreign investment in order to accelerate growth.
 Rostow’s model states that countries may need
to depend on a few raw material exports to
finance the development of manufacturing
sectors which are not yet of superior
competitiveness in the early stages of take-off.
In that way, Rostow’s model does not deny John
Maynard Keynes in that it allows for a degree of
government control over domestic development
not generally accepted by some ardent free
trade advocates.
• As a basic assumption, Rostow believes that
countries want to modernize as he describes
modernization, and that the society will ascent to
the materialistic norms of economic growth.
 Traditional Societies
• Traditional societies are marked by their
pre-Newtonian understanding and use of
technology. These are societies which
have pre-scientific understandings of
gadgets, and believe that gods or spirits
facilitate the procurement of goods, rather
than man and his own ingenuity. The
norms of economic growth are completely
absent from these societies.
 Preconditions for Take-off
• The preconditions to take-off are, to
Rostow, that the society begins committing
itself to secular education, that it enables a
degree of capital mobilization, especially
through the establishment of banks and
currency, that an entrepreneurial class
form, and that the secular concept of
manufacturing develops, with only a few
sectors developing at this point. This leads
to a take off in ten to fifty years.
 The Take-off
• Take-off then occurs when sector led
growth becomes common and society is
driven more by economic processes than
traditions. At this point, the norms of
economic growth are well established.
• Transition from traditional to modern
economy
 The Drive to Maturity
• The drive to maturity refers to the need for
the economy itself to diversify. The sectors
of the economy which lead initially begin to
level off, while other sectors begin to take
off. This diversity leads to greatly reduced
rates of poverty and rising standards of
living, as the society no longer needs to
sacrifice its comfort in order to strengthen
certain sectors.
Age of High Mass Consumption
• The age of high mass consumption refers to the
period of contemporary comfort afforded many
western nations, wherein consumers
concentrate on durable goods, and hardly
remember the subsistence concerns of previous
stages.
• in the age of high mass consumption, a society
is able to choose between concentrating on
military and security issues, on equality and
welfare issues, or on developing great luxuries
for its upper class.
 Criticism
• Strong bias towards western model of
modernization (free vs. controlled markets,
China).
• Tries to fit economic progress into a linear
system (many countries make false starts,
Russia).
• It considers mostly large countries: countries
with a large population (Japan), with natural
resources available at just the right time in its
history (Coal in Northern European countries), or
with a large land mass (Argentina).
 Harrod-Domar Growth Model
(AK Model)
• Following on Rostow’s theory the AK model
describes the mechanism by which more
investment leads to more growth.
• Pointed to the necessity of net additions to the
capital stock
• Used to explain an economy's growth rate in
terms of the level of saving and productivity of
capital.
• It suggests there is no natural reason for an
economy to have balanced growth.
 Concepts of Growth
• Warranted growth – the rate of output growth at which
firms believe they have the correct amount of capital and
therefore do not increase or decrease investment, given
expectations of future demand.
• Natural rate of growth – The rate at which the labour
force expands, a larger labour force generally means a
larger aggregate output.
• Actual growth – The actual aggregate output change.
• There is no guarantee that an economy will achieve
sufficient output growth to sustain full employment in a
context of population growth.
• The problem arises when actual growth either exceeds
or fails to meet warranted growth expectations. A vicious
cycle can be created where the difference is
exaggerated by attempts to meet the actual demand,
causing economic instability.
 Components
– Capital stock (K)
– Output (Y) - GDP
– Capital-Output ratio (k): the dollar amount of
capital needed to produce a $1 stream of
GDP. K/Y or ΔK/ΔY
– Savings (S) and the savings ratio (s): the fixed
proportion of national output that is used for
new investment.
• K/Y = k or

• ΔK /ΔY =k or
• ΔK = k ΔY or

• I= k ΔY
So S = sY (1)
• Net investment is the change in the capital stock
I = ΔK (2)
• Remember that k = K/Y or ΔK/ΔY, so that
ΔK = kΔY (3)
• Net savings must equal to net investment so that
S = I. Combining (1), (2) and (3):
sY = kΔY
s/k = ΔY/Y
ΔY/Y is the growth rate of GDP.
• Increasing the savings rate, increasing the
marginal product of capital, or decreasing
the capital output ratio will increase the
growth rate of output;
• So the growth rate of GDP is determined
jointly by the savings ratio, s, and the
national capital-output ratio
• So the rate of growth of GDP is positively
related to the economies savings ratio and
negatively related to the economies
capital-output ratio.
• The more economies save and invest, the
faster they can grow but the actual rate of
growth is measured by the inverse of the
capital-output ratio –
• The fact that LDCs savings levels
are often not enough to meet the
levels suggested by the linear-
stages models, the need to fill the
“savings gap” was used to justify
massive transfers of capital and
technical assistance from
developed countries to LDCs.
• .
• More savings and investment is not a
sufficient condition for accelerated rates of
economic growth. Many LDCs lack the
necessary structural, institutional and
attitudinal conditions to convert new capital
effectively into higher levels of output. They
also lacked the complementary factors of
production (e.g. skilled labour and managerial
competence).
• Also the development strategies proposed by
the stages models failed to take into account
the global environment in which developing
countries exist
 Structural Change Models
– Lewis Two-Sector Model
– Patterns-of-Development Approach
• These models tend to emphasize the
transformation of domestic economic
structures from traditional subsistence
agriculture economies to more modern,
urbanized and industrially diverse
manufacturing and service economies.
 Structural-Change Models
• Structural-change theory focuses on the
mechanism by which underdeveloped
economies transform their domestic
economic structures from traditional to an
industrial economy
• Representative examples of this strand of
thought are
– The Lewis theory of development
– Chenery’s patterns of development
 Lewis Two-Sector Model
• The economy consists of two sectors
– The traditional agricultural sector is typically
characterized by low wages, an abundance of
labour, and low productivity through a labour
intensive production process.
– the modern manufacturing sector is defined by
higher wage rates than the agricultural sector,
higher marginal productivity, and a demand for
more workers initially Labour can be withdrawn
from the traditional sector without any loss of
output

• .
• Focus is on labour transfer and output and
employment growth in the modern sector.
The rate at which this occurs is
determined by the rate of industrial
investment and capital accumulation in the
modern sector.
• Wages in the industrial sector are fixed at
a premium above wages in the traditional
sector. It is assumed that rural labour
supply is perfectly elastic
• Lewis assumed that with the urban
wage above the average rural wage,
that the modern-sector employers could
hire as many surplus rural workers as
the wanted without fear of rising wages
•The successive reinvestment of profits
from the modern sector would increase
the production possibilities of that sector
leading to successive increases in the
demand for labour.
• The employment expansion in the industrial
sector would continue until all the excess labour
from the traditional sector is absorbed. From that
point onwards, modern sector wages would rise
in order for industrial employers to attract
additional workers from the traditional sector.
• Improvement in the marginal productivity of
labour in the agricultural sector is assumed to be
a low priority as the hypothetical developing
nation's investment is going towards the physical
capital stock in the manufacturing sector.
• Over time as this transition continues to take
place and investment results in increases in
the capital stock, the marginal productivity of
workers in the manufacturing will be driven
up by capital formation and driven down by
additional workers entering the
manufacturing sector. Eventually, the wage
rates of the agricultural and manufacturing
sectors will equalize as workers leave the
agriculture for the manufacturing, increasing
marginal productivity and wages in the
agriculture while driving down productivity
and wages in manufacturing.
• .
• The end result of this transition process is
that the agricultural wage equals the
manufacturing wage, the agricultural
marginal product of labour equals the
manufacturing marginal product of labour,
and no further manufacturing sector
enlargement takes place as workers no
longer have a monetary incentive to
transition
• One of the problems with Lewis’ model is that it
assumes that the rate of labour transfer and
employment creation is proportional to the rate of
modern sector capital accumulation. It does not
leave room for the possibility that capitalist
profits could be reinvested in labour-saving
capital equipment nor does it leave room for the
possibility of capital flight.

• The model also assumes surplus labour in rural

areas and full employment in urban areas. By
and large this is not the case in most developing
nations.
•The assumption of a competitive
modern-sector labour market that
allows modern sector wages to remain
fixed until the rural sector labour
surplus is exhausted is unrealistic. In
reality there is a tendency for urban
wages to rise over time, even when
there is considerable urban
unemployment.
 Structural Changes an Patterns of
Development : Chenery’s Model
• Patterns of development theorists view
increased savings and investment as necessary
but not sufficient for economic development
• In addition to capital accumulation,
transformation of production, composition of
demand, and changes in socio-economic
factors are all important
• Chenery and colleagues examined patterns of
development for developing countries at
different per capita income levels
• The empirical studies identified several
characteristic features of economic
development:
– Shift from agriculture to industrial production
– Steady accumulation of physical and human
capital
– Change in consumer demands
– Increased urbanization
– Decline in family size
– Demographic transition
• Differences in development among the
countries are ascribed to:
– Domestic constraints
– International constraints

• To summarize, structural-change analysts

believe that the “correct mix” of economic
policies will generate beneficial patterns of
self-sustaining growth
• Both domestic and international constraints on
development are emphasized.
• Domestic constraints: country’s resource
endowment and physical population,
government policies and objectives.
• International constraints: External capital,
technology and international trade.
• The extent to which countries face these
constraints determines their development level.
• Recognition is given to the importance of the
integrated international system in which
developing countries belong – a system that can
promote or hinder their development.
 International-Dependence
Revolution
• Neocolonial Dependence Model
• False-Paradigm Model
• Dualistic-Development Thesis
The international-dependence models grew
out of the increasing disenchantment with
both the stages-of-growth and structural-
change models only for them to fall out of
favor in the 80’s and 90’s as the
neoclassical models took over in
importance.
These models view developing countries as
beset by institutional, political, and economic
rigidities both domestic and international,
and caught up in a dependence and
dominance relationship with rich countries.
Neocolonial Dependence Model
• Direct outgrowth of Marxist thinking. It lays
the blame for the existence of
underdevelopment on the shoulders of the
historical evolution of a highly unequal
capitalist system of rich country-poor country
relationships.
• The dominance of the unequal power
relationships between the center (the rich
countries) and the periphery (the developing
countries) renders the attempts by the LDCs
to be self-sufficient and independent difficult.
Also the members of the elite class in the
developing countries have interests that help to
perpetuate the international capitalist system of
inequality and conformity. Directly and indirectly
the elite class serve and are rewarded by
international special-interest power groups (e.g.
multi-national corporations, multilateral
assistance organizations like the IMF), which are
tied by the allegiance or funding to the wealthy
capitalist countries. Often, elite activities tend to
hinder any reform efforts that might benefit the
population at large leading to perpetual
underdevelopment.
• The continuing poverty in the developing world is
largely attributed to the existence and policies of
the industrial capitalist countries and their
extensions in the form of small but powerful elite
groups in LDCs.
• Underdevelopment is seen as an externally-
induced phenomenon. Dependent countries can
only expand as a reflection of the expansion of
the dominant countries. Dependence causes the
dependent nations to be both backward and
exploited.
• Revolutionary struggles or at least the
restructuring of the world capitalist system are
therefore required.
 The False-Paradigm Model
• Less radical than international dependence models,
these models attribute underdevelopment to faulty and
inappropriate advice provided by well-meaning but
often uninformed, biased and ethnocentric
international advisers from developed-country
assistance agencies and multinational donor
organizations.

• The advice given fails to recognize resilient traditional

social structures, the highly unequal ownership of land
and other property rights, the disproportionate control
of elites over domestic and international financial
assets and the very unequal access to credit.
 The False-Paradigm Model

• The policy advice generated from classical

and neo-classical models in many cases
merely serve to protect the interests of the
existing power groups, both domestic and
international.
• Also local university intellectuals, high-
government officials and other civil servants
receive training in developed-country
institutions where they learn inapplicable
theoretical models.
 Dualistic Development Thesis
• The concept of dualism represents the existence and
persistence of increasing divergences between rich
and poor nations, and rich a poor peoples on various
levels.
• Four elements of dualism:
1. Different sets of conditions, of which some are superior and
others inferior, can coexist in a given space.
2. The coexistence is chronic and not transitional.
3. The degrees of superiority or inferiority have a tendency to
increase over time.
4. The superior element does little or nothing to pull up the
inferior element and may in fact serve to push it down.
The Neoclassical Counterrevolution
• The counterrevolution called for freer markets
and the dismantling of public ownership, statist
planning, and government regulation of
economic activities.
• Neoclassicist also obtained controlling power of
the world’s two most influential international
financial agencies - the World Bank and the
International Monetary Fund (IMF).
• Neoclassical counterrevolution argues that
underdevelopment is the result of poor resource
allocation due to incorrect pricing policies and too much
state intervention by overly-active developing-nation
governments and that state intervention often slows the
pace of economic growth.
• The belief is that by allowing free markets to flourish,
privatizing state-owned enterprises, promoting free trade
and export expansion, welcoming investment from
developed countries and removing the plethora of
government regulations and price distortions in factor,
product and financial markets, both economic efficiency
and economic growth will be stimulated.
• The Free Market Approach: markets alone
are efficient, competition is effective if not
perfect, technology is freely available and
nearly costless to absorb, information is
also perfect and nearly costless to obtain.
So government intervention in this context
is distortionary and counterproductive.
Ignores market imperfections in
developing countries.
• .
• Public-choice theory: Government
can do nothing right. Politicians,
bureaucrats, citizens and states are
all self-interested and take action to
achieve their own ends. Minimal
government is the best government
• Market-friendly Approach: Recognizes the
imperfections in LDC product and factor
markets and recognizes the need for
government to facilitate the operation of
markets through market-friendly
interventions. Also recognizes that marker-
failures are more prominent in developing
countries.
• The problem with the arguments of the
neoclassical counterrevolution is that most
LDC economies are so different in
structure and organization from the
developed countries that the behavioural
assumptions and policy prescriptions are
often incorrect.
– Markets are hardly competitive
– The invisible hand often acts to promote the
welfare of those who are already well-off while
pushing down the vast majority.
 Solow Model

• Solow and T.W. Swan developed a model

called Solow Model which is extension of
the Harrod-Domar Model by adding a
second factor of production – labour – and
by Introducing a time-varying technology
variable distinct from capital and labor.
Solow received the Nobel Prize in
Economics for his work.
• there are three basic inputs to the
production function of an economy: labor,
capital and technology. Land, natural
resources are fixed
• The production function assumes to have
constant returns to scale; means doubling
the labor and capital doubles the output.
• The Solow Model allows for substitution
between capital and labor
• Suppose production function is
• Y = K α( AL)1-α
• As A is constant we can write it as
• Y = AKαL1-α
• There are diminishing returns to labor and
capital
• The level of technological progress was
assumed to be exogenous
• Labor force grow at constant rate “n”
• Y = A Kα L1-α
• Constant returns to scale:
• F(λK,λL) = λ F(K,L) = λA Kα L1-α
• F(λK,λL) = λ F(K,L)
• λ Y= F(λK,λL)
• If λ = 1/L then
• Y/L = F (K/L ,1 )
• Or y= f (k)
• where y=Y/L ,output per unit of labor
• And k = K/L , capital per unit of labor
• So y = Akα
• The equation shows that output per worker
depends on the amount of capital per
worker in the presence of existing
technology.
• As S=sY and I=S
• Then sY = I
• And i=sy
• Or i=sf(k)
• The labor force grows at the rate “n”
• The growth rate of labor productivity is
represented by “A” which is λ in this case.
• k grows when investments or savings are
greater than replacement investment . This
growth in capital per labor is called “capital
deepening”
• If depreciation is d then capital (n+d)k is
required to keep capital per labor constant, is
called “capital widening”
• When sy> (n+d)k capital per worker
increases
• When sy < (n+d)k capital per worker
decreases
• The curves intersect at point A, the
"steady state". At the steady state, output
per worker is constant. However total
output is growing at the rate of n, the rate
of population growth.
Golden Rule
• Suppose there is increase in s as a result
economy moves from point A to B it
results in increase of k and y. There is a
small increase in y but there is a great
decrease in consumption ( difference
between yo and A is greater than the
difference between y1 and B).
 Golden Rule
• The Golden Rule level of capital
accumulation is the steady state with the
highest level of consumption. The
government can move the economy to a
new steady state, where consumption is
maximized. To alter the steady state, the
government must change the savings rate.
• The point is where MPk= (n+d)k
Effect of population growth
• The long-run rate of growth is exogenously
determined by the rate of technical progress .
However, the rate of technological progress
remain unexplained.
• Any increase in GNP that cannot be attributed
to short term adjustments to labor and capital,
is called Solow Residual, is responsible for
roughly 50% of historical growth.
• According to Solow the long run growth of
the economy is equal to population growth
“n”. If population growth of two countries is
same, it means that the growth rate of
countries is also same which is not
historically proved.