Chap 3

Chapter 3
Theories of
Economic Growth
and Development
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Theories by classification…
3.1 Theories of resources constrains

- Malthus
- Household utility maximization
- Vent-for-surplus
- Staple-theory
- Dutch disease
3.2 Traditional theories of International Trade
- Theory of Adam Smith
- Theory of David Ricardo
3.3 Linear-stages-of-growth model
- Rostow model
- Harrod-Domar model
3.4 Exogenous growth model (Solow model)
3.5 Endogenous growth model (Romer model)
3.6 Contemporary Models (Big Push, O-Ring)
3.1 Theories of resource
constrains
• 3.1.1 Malthus
• 3.1.2 Household utility maximization
• 3.1.3 Dutch Disease
• 3.1.4 Vent-for-surplus
• 3.1.5 Staple theory
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Thomas Robert Malthus
(1766-1834)
3.1.1 Malthusian Model
Observation
Population:
million
Source: Colin
McEvedy and
Richard
Jones, Atlas of
World
Population
History (1978),
p. 342.

Malthusian Model & the History
Source: Gregory Clark, Farewell to Alms: A Brief Economic History of

the World (2007), p. 2.
The Black Death (1348–1350)
- Killed more than 20

million people in Europe
(~ 1/3 of the continent’s
population.)
Source:
http://www.history.com/topics/
black-death
The Malthusian population trap
– The idea that rising population and diminishing

returns to fixed factors result in a low levels of
living (population trap)

The Malthusian Population Trap

The Malthusian Population Trap
Solution
=> poor nations will never be able to rise much

above their subsistence levels of per capita
income unless:
- Preventive checks (birth control)
- Else, positive checks (starvation, disease, wars)
will inevitably provide the restraining force

Criticisms of the Malthusian model
– Impact of technological progress

– No correlation between population growth and
levels of per capita income
– Microeconomics of family size; individual and
not aggregate variables
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How Technological and Social
Progress Allows Nations to Avoid the
Population Trap

3.1.2 The household utility
maximization
• The microeconomic household theory of fertility

• Assumption: The demand for children in
developing countries is determined by family
preferences for a certain number of surviving
children by
– the price (“opportunity cost”) of rearing these children,
– levels of family income
– Children are considered as “consumer goods” or
“investment goods”?

maximization
Demand for Children Equation
Cd  f (Y , Pc, Px, tx ), x  1,..., n

Where
Cd is the demand for surviving children
Y is the level of household income
Pc is the “net” price of children
Px is price of all other goods
tx is the tastes for goods relative to children

maximization

maximization
Demand for Children Equation
Cd  f (Y , Pc, Px, tx ), x  1,..., n
Under neoclassical conditions, we would expect:
Cd Cd
0 0
Y Px
Cd Cd
0 0
Pc tx

Estimated World Population
Growth

maximization
• Some empirical evidence

• Implications for development and fertility
1. Women’s Education, role , and status
2. Female nonagricultural wage employment
3. Rise in family income levels
4. Reduction in infant mortality
5. Development of old-age and social security
6. Expanded schooling opportunities

World Population Growth, 1750-
2050

World Population Growth Rates
and Doubling Times

World Population Distribution by
Region, 2003 and 2050

Table 5.3 Fertility Rate for Selected
Countries, 1970 and 2006

Population Pyramids: Ethiopia and the
United States, 2005

The Demographic Transition
• Stage I: High birthrates and death rates

• Stage II: Continued high birthrates, declining
death rates
• Stage III: Falling birthrates and death rates,
eventually stabilizing

Figure 5.5 The Demographic
Transition in Western Europe

3.1.3 Dutch Disease
• Dutch disease:
– the negative impact on an economy of anything
that gives rise to a sharp inflow of foreign
currency, such as the discovery of large oil
reserves [http://lexicon.ft.com/Term?term=dutch-disease]
– windfall revenues from natural resources give
rise to real exchange rate appreciation, which in
turn reduces the competitiveness of the
manufacturing sector (Oomes & Kalcheva, 2007)

3.1.3 Dutch Disease
• Resource endowments: A nation’s supply of

usable factors of production including
mineral deposits, raw materials, and labor.

Case study: Oil price shocks
and Netherlands
Nguồn: http://energy.gov/eere/office-energy-efficiency-renewable-energy

Case study: Oil price shocks
and The Netherlands
• After WWII: The traditional export sector (agricultural and
electronics) is very competitive => low inflation, low
unemployment, good GNP
• Early 1970s: Significant reserves of natural gas were found
• 1973-1975: gas exports => 10% export growth, GNP + 4%
increase.
• Guilder increased => lost 30% traditional customers +
costs increased => P increased rapidly from 2% (1970) to
10% (1975) => GNP fell to 1%.
2-29
3.2 Traditional Theories of
International Trade
• Factor endowment trade theory:
postulates that countries will tend to
specialize in the production of the
commodities that make use of their
abundant factors of production (land, labor,
capital, etc.).
• Specialization: Concentration of resources
in the production of relatively few
commodities.
2-30
3.1 Theories of resource
constrains
• 3.1.1 Malthus
• 3.1.2 Household utility maximization
• 3.1.3 Dutch Disease
• 3.1.4 Vent-for-surplus
• 3.1.5 Staple theory

3.2 Traditional Theories of
International Trade
• Adam Smith:
– Invisible hand
– Absolute advantage
• David Ricardo:
– Comparative advantage
2-32
3.3 Linear-stages-of-growth
model
• Harrod – Domar Model
• Rostow Model

3.3.1 Harrod-Domar Model
• A classical Keynesian
model of economic
growth.
• Developed
independently by
Roy F. Harrod in
1939 and Evsey
Domar in 1946

3.3.1 Harrod-Domar Model
Observation
• LDCs have much less capital per worker

than rich countries.
• “Capital” = machinery and equipment
• Result: Lower productivity of labor
• And thus Lower wages/incomes.
• LDCs are poor because they lack capital

The Harrod-Domar Model
• S = sY (3.1) Savings rate s

• I = ∆K (3.2) Invest = ΔCapital
• ∆K = k∆Y (3.3) Capital/Output = k
•S=I (3.4) Closed Economy

The Harrod-Domar Model
=>
Y s

Y k
=> Growth rate of GDP = savings rate/capital-
output ratio => To increase GDP growth,
increase s (or foreign S)

Criticisms of the Harrod-Domar
Model
• Necessary versus sufficient conditions
• Is Saving necessary for growth?
– Not if foreign investment or foreign aid (World Bank
Loans, etc.)
• Is Saving (Investment) sufficient for growth?
– Are there institutions to channel savings to productive
uses: a well-functioning financial system or government
plan?
=> Harrod-Domar model was the precursor to the
exogenous growth model (Solow, Solow-Swan model)
2-38
3.3.2 Rostow Model
- Walt Whitman Rostow (1916 – 2003)

- Famous for his role in the shaping of
US foreign policy during the 1960s
- Famous work:
The Stages of Economic Growth: A No
n-Communist Manifesto
(1960).
- Advisor for Eisenhower (1953-1961),
Kennedy (1961-1963), Johnson (1963-
1969)
Source: https://en.wikipedia.org/wiki/Walt_Whitman_Rostow

3.3.2 Rostow Model

3.4 Exogenous growth model
Solow model
• A neoclassical model
of economic growth.
• Developed by Robert
Solow (1956)
• 1987: awarded the
Nobel Prize in
Economics for his work.
• See Macroeconomics 2
2-41
The role of capital accumulation Production
Function
• The Supply of Goods and the Production
Function: Y = F(K,L)
• The production function has constant returns to
scale: zY = F(zK, zL)
• Set z = 1/L => Y/L = F(K/L, 1)
– Y/L: output per worker
– K/L: capital per worker
 designate quantities/worker with lowercase letters
 y = Y/L and k = K/L
=> Production function: y = f(k)
slide 42
Output, Consumption,
Investment
slide
43
Investment, Depreciation &
the Steady State
slide
44
How Saving Affects Growth
• Saving rate s1 => the steady state k1*
• If s => i = sf(k)  => k2* 
slide
45
Technological Progress in the
Solow Model
slide
46
Steady-State Growth Rates in the
Solow Model with Technological
Progress
Variable Symbol Growth

Rate
Capital per effective worker k = K/(E x L) 0
Output per effective worker y = Y/(E x L) = f(k) 0
Output per worker Y/L = y x E g
Total output Y = y x (E x L) n+g
slide
47
The Effects of Technological Progress
 At the steady-state:
– k,y unchange, but Y = (y x L x E) grows at
rate (n+g)
– Y/L = y x E => output per worker
(productivity) grows at rate g.
– A high rate of saving leads to a high rate
of growth only until the steady state is
reached…
– Technological progress can help y grows
at rate g when the economy is in the
slide
steady state 48
3.5 Endogenous growth model
Romer model
• Paul Michael
Romer (1955): American
economist, pioneer
of endogenous growth
theory
• Technological change is
the result of the intentional
actions of people, such as
research and
development
2-49
The evolution of Romer Model:
Solow Model Romer Model

Technological change is Technological change is
exogenous endougenous
The sources of growth and explained

technological progress are left
unexplained.
The attributes of economic goods
What is
economic
goods ???
Economic goods:
+ the degree to which it is
rivalrous
+ the degree to which it is
excludable
Rivalry: when you

use it, everyone else
cannot use it
Non-rivalry
goods: one person
uses it, other can use it.
Excludability:
restriction of access of use,
set by legal system.
=> Rivalry is closely related to excludability

Rivalry Excludability
Market goods
Public goods
Knowledge
Rivalry Excludability
Market goods Yes Yes
Public goods No No
Knowledge No Yes (Partially)
Knowledge/Design Human capital

Rivalry Non-rivalry Rivalry
Dependent => lose when
physical body is lost
Independent => growth
Physical body
without bound
As much as the previous

Cost of replication None
"Endogenous Technical Change"
(Romer, 1990)
Assumptions:
- Inputs: K, L, H (rivalrous), A – technological component (non-rivalrous1)
- Fixed H: H = HA + HY
HA: human capital in the design section
HY: human capital in the final goods section
- L & H are different
- Final goods & capital goods use the same technology
- There are 3 sections
+ Research sector: HA + existing stock of knowledge => new knowledge (designs).
+ intermediate-goods sector: designs2 + forgone output => durable goods for final goods
production
+ final goods sector: L + HY + durable goods => final output.
(Romer, 1990)
Final goods Double the Double the Double both
production rivalrous non-rivalrous the rivalrous
input (X) input (A) & non-
rivalrous
inputs (X, A)
Design 10.000h => 10.000h => 20.000h => 20.000h =>
20MB 20MB 30 MB 30MB
Labor 100 200 100 200
Capital $10m $20m $10m $20m
Output 100.000 200.000 100.000 200.000

(hard-disk)
Output 20*100.000 20*200.000 30*100.000 30*200.000
(MB) = 2m MB = 4m MB = 3m MB = 6m MB
(Romer, 1990)
• F (A, 2X) = 2F(A,X)

• F (2A,2X) > 2F(A,X)
=> the stock of human capital determines the rate of growth

Contemporary Models
• The Big Push

• Michael Kremer’s O-Ring Theory of
Economic Development

The Big Push Theory
• Pioneered by Paul Rosenstein-Rodan (1940s),

who first raised some of the basic coordination
issues
• The approach was in turn simplified and
popularized by Paul Krugman in his work in 1995
=> became the classic model of the new
development theories of coordination failure of the
1990s

The Big Push Theory
Question: who will buy the goods produced by the 1 st

firm to industrialize?
– The 1st factory can sell its goods to its own workers, but
no one spends all of one’s income on a single good.
=> profitability of one factory depends on whether another
one opens => depends on its own potential profitability => a
pattern of a coordination failure problem
=> Need a Big push (e.g. from the Gov.) to initiate the
development process

The Big Push Theory
• Assumptions
– Factors. only one factor of production—labor, it
has a fixed total supply, L.
– Factor payments. The labor market has two
sectors
• Traditional sector: workers receive a wage of 1
• Modern sector: workers receive a wage W > 1 (that
is, some wage that is greater than 1).
2-64
The Big Push Theory
• Assumptions (cont.)
– Technology.
• N types of products,
• Traditional sector: 1 worker produces 1 unit of output
=> constant returns-to-scale production
• Modern sector, there are increasing returns to scale.
– no product can be produced unless a minimum of F
workers are employed (we are keeping things simple => do
not put capital in the model => the only way to introduce a
fixed cost is to require a minimum number of workers)
– L = F + cQ (c<1: the marginal labor required for an
extra unit of output)
2-65
The Big Push Theory
• Assumptions (cont.)
– Domestic demand.
• each good receives a constant and equal share of
consumption
• no saving
Þ consumers spend an equally amount: Y/N
– Closed economy
– perfect competition in the traditional sector
2-66
The Big Push Theory

The Big Push Theory
• Traditional sector:
– each worker produces one unit of output => the
slope of production line = 1
– the wage bill line lies coincident with the
production line1
• Modern sector:
– Firm requires F workers before it can produce
anything, but after that, it has a linear technique
with slope 1/c > 1
– the wage bill line has slope W > 1 2-68
The Big Push Theory
• Price = 1 => PQ can be read off the Q axis

• At modern wage W1 (below point A)
– revenues (Q1) > costs (W1)
– Modern firm will pay the fixed cost F and enter the market.
– By assumption, production functions are the same for each
good => modern firm finds it profitable to produce one good, the
same incentives will be present for other goods => industrialize
– demand is now high enough that we end up at point B for each
product.
=> coordination failure need not always happen: It depends on the
technology and prices (including wages) prevailing in the
economy.
2-69
The Big Push Theory
• If the wage = W2 => two possible outcomes:
– Only one modern firm enters the market
• revenues < costs => no modern firm enters => no industrialization, wages
and output remain low
– Modern firms enter in all markets
• wages ↑ to W2 in all markets => income ↑.
• Modern firms can now sell all of its expanded output (at point B), produced
by using all of its available labor allocation (L/N), because it has sufficient
demand from workers and entrepreneurs in the other industrializing product
sectors.
• Workers are well off than in traditional sector (higher wage, purchase higher
quantity of goods) => they have changed sectors (from traditional to
modern) voluntarily.
• The latter is better, but in general, the market will not get there by
itself.
2-70
The Big Push Theory
• If wage = W3
– even if modern producers entered in all product
sectors, they still lose money => the traditional
technique would continue to be used.

The Big Push Theory
Generally
- wage line < point A: the economy to modernize
- The steeper (more efficient) the modern-sector production
technique or the lower the fixed costs, the more likely it is that
the wage < point A.
- Wage line > point A:
- Wage line > point B: no sense to industrialize
- A < Wage line < B:
- there would be two scenarios: with industrialization (point B) and
without industrialization (point A).
- it is efficient to industrialize, but the market will not achieve this on
its own because of coordination failure.=> the role for policy in
starting the economic development
2-72
The Big Push Theory
• Drawbacks
– We could have cases of semi-industrialization => could
have three or more equilibria
– did not assume the existence of technological
externality, in which the presence of one advanced firm
can, through “learning by watching” other firms’
production methods => generate spillovers effects to
raise their productivity or lower their costs (another type
of market failure)
2-73
Michael Kremer’s O-Ring Theory
• The name for Kremer’s model is taken from

the 1986 Challenger disaster2, in which the
failure of one small, inexpensive part
caused the space shuttle to explode.
• The O-ring explains not only the existence
of poverty traps but also the reasons that
countries caught in such traps may have
exceptionally low incomes compared with
high-income countries.
Michael Kremer’s O-Ring
Theory
• Assumption:
– production process is broken down into n tasks.
– To complete these tasks, “level of skill” q is needed,
where 0 ≤ q ≤ 1 (higher q => higher level of successfully
completed)
– Firms are risk-neutral, labor markets are competitive,
and workers supply labor inelastically (i.e., they work
regardless of the wage).
– If we consider capital markets => they are competitive
as well.
– Closed economy
Theory
• O-ring Production function:
– A production function with strong complementarities
among inputs, based on the products (i.e., multiplying)
of the input qualities.
– Output is given by multiplying the q values of each of
the n tasks together, in turn multiplied by a term, say, B,
that depends on the characteristics of the firm and is
generally larger with a larger number of tasks.
– If each firm hires only two workers, and B = 1:
BF(qiqj) = qiqj
2-76
Theory
• positive assortative matching:
– everyone will like to work with the more productive
workers, because if your efforts are multiplied by those
of someone else (as in the production function
equation), you will be more productive when working
with a more productive person.
=> workers with high skills will work together and workers
with low skills will work together
=> high-value products will be concentrated in countries
with high-value skills

Theory
• Example:
– imagine a four-person economy with two high-skill qH
workers and two low-skill qL workers.
– The 4 workers can be arranged either as matched skill
pairs or unmatched skill pairs.
– Total output will always be higher under a matching
scheme because
q2H + q2L > 2qHqL
• => workers sort out by skill level.
2-78
Theory
• This positive assortative matching process
make some workers/firms/economy fall into
a trap of low skill and low productivity, while
others escape into higher productivity.
Þ help to explain
- the poor and the rich countries,
- why rich countries produce more complicated
products, have larger firms and higher worker
productivity than poor countries
Chapter conclusion
• What does this chapter focus?
2-80

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Chapter 3

Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

3.1 Theories of resources constrains

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Source: Gregory Clark, Farewell to Alms: A Brief Economic History of

- Killed more than 20

– The idea that rising population and diminishing

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=> poor nations will never be able to rise much

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– Impact of technological progress

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• The microeconomic household theory of fertility

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Demand for Children Equation

Cd  f (Y , Pc, Px, tx ), x  1,..., n

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• Some empirical evidence

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• Stage I: High birthrates and death rates

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• Resource endowments: A nation’s supply of

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• LDCs have much less capital per worker

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• S = sY (3.1) Savings rate s

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- Walt Whitman Rostow (1916 – 2003)

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Variable Symbol Growth

Solow Model Romer Model

The sources of growth and explained

Rivalry: when you

=> Rivalry is closely related to excludability

Knowledge/Design Human capital

As much as the previous

Output 100.000 200.000 100.000 200.000

• F (A, 2X) = 2F(A,X)

=> the stock of human capital determines the rate of growth

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• The Big Push

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• Pioneered by Paul Rosenstein-Rodan (1940s),

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