Economic Development

Thirteenth Edition

Chapter 3
Classic Theories of
Economic Growth and
Development

Copyright © 2020, 2015 Michael P. Todaro and Stephen C. Smith

3.1 Classic Theories of Economic Development:
Four Approaches
• Linear stages of growth model
• Theories and patterns of structural change
• International-dependence “revolution”
• Neoclassical, free market “counterrevolution”

Copyright © 2020, 2015 Michael P. Todaro and Stephen C. Smith

 3.2 Development as Growth and Linear-
Stages Theories
• A Classic Statement: Rostow’s Stages of Growth
• Harrod-Domar Growth Model
• (Also referred to as the AK model, because the
capital stock is multiplied by a constant factor,
sometimes called “A”)

Copyright © 2020, 2015 Michael P. Todaro and Stephen C. Smith

 Simplified Harrod-Domar Growth Model
• Sometimes called the “AK model”
• Harrod-Domar Growth Model Derivation
• Y = (1/c)*K
• Linear relationship assumed, so,
• ΔY = (1/c)*ΔK; or,
• ΔY = SNet/c
• Dividing by Y: ΔY/Y = (SNet/Y)/c; so,
• Growth = (sNet)/c; that is,
• Growth = Net savings rate/ICOR

Copyright © 2020, 2015 Michael P. Todaro and Stephen C. Smith

The Harrod-Domar Model – Simplified
Version, Alternate Derivation

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The Harrod-Domar Model – Simplified Version

Copyright © 2020, 2015 Michael P. Todaro and Stephen C. Smith

 The Harrod-Domar Model – Incorporating
Capital Depreciation
• Equation 3.7 is also often expressed in terms of gross savings, in
which case the growth rate is given by

(3.7’)

where δ is the rate of capital depreciation

The derivation follows in the next two slides:

Copyright © 2020, 2015 Michael P. Todaro and Stephen C. Smith

Harrod-Domar (or “AK”) Model: Derivation of
disaggregated treatment of depreciation

And,

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Harrod-Domar (or “AK”) Model: Derivation of
disaggregated treatment of depreciation
(Continued)

So,

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Illustrative Exercise on Growth Potential

‘Back-of-the-envelope’ calculations with the H-D

(or AK) growth model.

Suppose sG = .125, =.04, c =2.5

Then,

But if sG = .175,  =.03, c =2.5

Then,

Copyright © 2020, 2015 Michael P. Todaro and Stephen C. Smith

 Illustrative Exercise: Growth Targets
• Suppose a country has a gross savings rate of 20%, a depreciation
rate of 3%, and an lCOR of 2.5
• Using the Harrod-Domar growth model, find the implied rate of
growth of total GDP in the country
• Answer: Growth = .2/2.5 - .03 = .05 (i.e., 5%)
• How much would the rate of savings have to increase to raise the
growth rate of total GDP to 9% (a target discussed in India)?
• Answer: Now the savings rate is your unknown.
• Growth = s/2.5 - .03 = .09 , so s/2.5 = .12 or s = .3 (that is, up 10
percentage points from 20% to 30%)
• Targeted growth rates and required savings are considered further
in Chapter 11
Copyright © 2020, 2015 Michael P. Todaro and Stephen C. Smith
 Criticisms of the Stages Model
• Necessary versus sufficient conditions

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 3.3 Structural-Change Models
• The Lewis two-sector model

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Figure 3.1
The Lewis Model of Modern-Sector Growth in a
Two-Sector Surplus-Labour Economy

Copyright © 2020, 2015 Michael P. Todaro and Stephen C. Smith

 Criticisms of the Lewis Model
• Rate of labor transfer and employment creation may
not be proportional to rate of modern-sector capital
accumulation
• Questionable assumption of surplus labor in rural
areas and full employment in urban
• Questionable assumption of diminishing returns in
modern industrial sector, at least in some cases
• Institutional factors have a small (if any) role in this
approach

Copyright © 2020, 2015 Michael P. Todaro and Stephen C. Smith

Figure 3.2
The Lewis Model Modified by Laborsaving
Capital Accumulation: Employment Implications

Copyright © 2020, 2015 Michael P. Todaro and Stephen C. Smith

 Empirical Patterns of Development -
Examples
• Some processes are very typical but not universal; so
these are often referred to as “stylized facts”:
‒ Switch from agriculture to industry (and services)
‒ Rural-urban migration and urbanization
‒ Steady accumulation of physical and human
capital
‒ Population growth first increasing and then
decreasing with decline in family size

Copyright © 2020, 2015 Michael P. Todaro and Stephen C. Smith

 3.4 The International-Dependence “Revolution”
• The neocolonial dependence model
– Legacy of colonialism, Unequal power, Core-periphery
• The false-paradigm model
– Pitfalls of using “expert” foreign advisors who misapply
developed-country models
• The dualistic-development thesis
– Superior and inferior elements can coexist; Prebisch-Singer
Hypothesis
• Criticisms and limitations
– Accumulating counterexamples; the framework does little
to show how to achieve development in a positive sense

Copyright © 2020, 2015 Michael P. Todaro and Stephen C. Smith

 3.5 The Neoclassical Counterrevolution, or
“Market Fundamentalism”
• Challenging the Statist Model: Free Markets, Public Choice, and
Market-Friendly Approaches
– Free market approach
– Public choice approach
– Market-friendly approach
• Main Arguments
– Denies efficiency of intervention
– Points up state owned enterprise failures
– Stresses government failures
– Urges reliance upon the “magic of the marketplace”
– Associated with a different (Solow) formal model of growth:

Copyright © 2020, 2015 Michael P. Todaro and Stephen C. Smith

 3.5 The Neoclassical Counterrevolution, or
“Market Fundamentalism”
• Associated with a different (Solow) formal model of
growth
‒ Traditional neoclassical growth theory (Solow model)
‒ Includes labor as a separate input
‒ Shows that with diminishing returns, growth cannot be
sustained by capital accumulation alone
‒ Adds separate, explicit accounting of the role of
technological change
‒ The model details are presented in Appendix 3.2

Copyright © 2020, 2015 Michael P. Todaro and Stephen C. Smith

 From the Appendix:
Interpreting the Solow equilibrium equation

• Interpreting of the Solow Equilibrium in Equation (A3.2.5) and

the preceding figure (A3.2.1),
• sf(k*) is savings per worker, and is just equal to the sum of:
• δk*, the amount of capital (per worker) needed to replace
depreciating capital, and,
• nk*, the amount of capital (per worker) that needs to be added
due to population (labor force) growth.

Copyright © 2020, 2015 Michael P. Todaro and Stephen C. Smith

 Contributions and Limitations of the
Four Schools
• Capital Fundamentalism
– Points up importance of investment, and of efficiency of capital allocation
– Investment may be necessary but is not sufficient. Broader context matters
• Structural/Empirical Patterns of Development
– Careful empirical evidence can remove theories from contention
– But, still need theory to interpret data, avoid cart-before-horse policies
• Dependency
– Existing international relations/ trade/ investment can place constraints on pattern
of development
– But, growing number of counter-examples of stronger versions of dependency
theory; good performance of “globally” integrated countries
• Market Fundamentalism
– Governments fail (e.g. in SOEs, planning) and we must account for this
– But, markets also fail in developing countries; the East Asia experience shows that
government role can be constructive

Copyright © 2020, 2015 Michael P. Todaro and Stephen C. Smith

 3.6 Classic Theories of Development:
Reconciling the Differences
• Governments do fail, but so do markets; a balance is
needed
• Must attend to institutional and political realities in
developing world
• Development economics has no universally accepted
paradigm
• Insights and understandings are continually evolving
• Each theory has some strengths and some
weaknesses

Copyright © 2020, 2015 Michael P. Todaro and Stephen C. Smith

 Appendix 3.1: Components of Economic
Growth
• Capital Accumulation, investments in physical and
human capital
– Increase capital stock
• Growth in population and labor force
• Technological progress
– Neutral, labor/capital-saving, labor/capital augmenting

Copyright © 2020, 2015 Michael P. Todaro and Stephen C. Smith

Figure A3.1.1
Effect of Increases in Physical and Human
Resources on the Production Possibility Frontier

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Figure A3.1.2
Effect of Growth of Capital Stock and Land on
the Production Possibility Frontier

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Figure A3.1.3
Effect of Technological Change in the Agricultural
Sector on the Production Possibility Frontier

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Figure A3.1.4
Effect of Technological Change in the Industrial
Sector on the Production Possibility Frontier

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 Appendix 3.2: The Solow Neoclassical
Growth Model
• Notation
‒ f(k*) is the production function relating capital per worker to
output; the function has diminishing returns; s is the savings
rate; So,
‒ sf(k*) is savings per worker;
‒ δ is the rate of capital depreciation;
‒ n is the rate of growth of the labor force;
‒ Savings per worker sf(k*) is just equal to the sum of:
‒ δk*: the amount of capital (per worker) needed to replace
depreciating capital, and,
‒ nk*: the amount of capital (per worker) that needs to be added -
due labor force growth – to keep capital per worker from falling

Copyright © 2020, 2015 Michael P. Todaro and Stephen C. Smith

Appendix 3.2 The Solow Neoclassical Growth
Model: The Solow Equation

Equilibrium is found where Δk = 0, as in equation A3.2.5 on the next slide.

Note: We can also use equation A3.2.4 above to provide a “heuristic” proof
by contradiction – making use of Figure A3.2.1 – to see that the equilibrium
must be where Δk = 0: otherwise k is growing to the left of k* and shrinking
if to the right of k*.

Copyright © 2020, 2015 Michael P. Todaro and Stephen C. Smith

 Equilibrium Condition in the Solow
Neoclassical Growth Model

Again:
s is the savings rate;
f(k*) is the production function relating capital per worker to output; the
function has diminishing returns; So,
sf(k*) is savings per worker
δ is the rate of capital depreciation; n is the rate of growth of the labor force;
Savings per worker sf(k*) is just equal to the sum of:
δk*: the amount of capital (per worker) needed to replace depreciating
capital, and,
nk*: the amount of capital (per worker) that needs to be added - due labor
force growth – to keep capital per worker from falling

Details of the model are examined in Appendix 3.2

Copyright © 2020, 2015 Michael P. Todaro and Stephen C. Smith
Figure A3.2.1
Equilibrium in the Solow Growth Model

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Figure A3.2.2
The Long-Run Effect of Changing the Saving
Rate in the Solow Model

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 The Solow Equation:
A Heuristic Numerical Example
• Note: This heuristic example addresses the capital per worker component,
not production (output per worker)
• Income depends upon capital (K) per worker (L): i.e., K/L
• Before K/L can grow we must invest to make allowance for a)
depreciation; and b) growth of the labor force L
• To illustrate, consider a 10-worker economy growing to 12 workers;
initially K/L = 2; and depreciation = .05
• To increase K/L to 2.5 we must invest:
‒ 1 unit of K for depreciation allowance: (20)*(.05) = 1
‒ 4 units of K for “capital widening” (equipping the new workers with the
same capital as the existing workers)
‒ 6 units of K for “capital deepening,” to finally increase the K/L ratio, up
to where each worker has 2.5 units of capital to work with
‒ Overall, the K stock grows from 20 to 30, i.e., 30/12 = 2.5

Copyright © 2020, 2015 Michael P. Todaro and Stephen C. Smith

 Supplementary Note: The Role of
Technology*
• If there is technological progress, income per worker can
increase proportionately
• Think of K in the Solow production function as multiplied by a
constant, A, “AK”:
• So far we have implicitly set A to 1; but it can grow over time,
representing productivity growth
• In equilibrium, if the “effective workforce” increases at rate l,
then the Solow equilibrium is:
• sf(k*) = (d + n + l)k*
• The “effective workforce” then grows faster than the (actual)
workforce, corresponding to an increase in output per worker
*This slide addresses a topic not explicitly explained or currently formalized in the text

Copyright © 2020, 2015 Michael P. Todaro and Stephen C. Smith

 Concepts for Review

• Autarky
• Average product
• Capital-labor ratio
• Capital-output ratio
• Center
• Closed economy
• Comprador groups
• Dependence
• Dominance
• Dualism
• False-paradigm model
• Free market
• Free-market analysis
• Harrod-Domar growth
model
• Lewis two-sector model
• Marginal product
• Market failure

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 Concepts for Review (Continued)

• Market-friendly approach • Production function

• Necessary condition
• Neoclassical counterrevolution
• Neocolonial dependence
model
• Net savings ratio
• New political economy
approach
• Open economy
• Patterns-of-development
analysis
• Periphery
• Public-choice theory
• Self-sustaining growth
• Solow neoclassical growth model
• Stages-of-growth model of
development
• Structural-change theory
• Structural transformation
• Sufficient condition
• Surplus labor
• Underdevelopment

Copyright © 2020, 2015 Michael P. Todaro and Stephen C. Smith