Chapter 1

Classic Theories
of Economic
Growth and
Development
 1.1 Classic Theories of Economic
Development: Four Approaches

1. Linear stages of growth model

2. Theories and Patterns of Structural Change

3. International-Dependence Revolution

4. Neoclassical, Free Market Counterrevolution

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 1.2 Development as Growth and
Linear-Stages Theories

• A Classic Statement: Rostow’s Stages of

Growth
• Harrod-Domar Growth Model (sometimes
referred to as the AK model)

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 A classic statement:
Rostow – Stages of Growth
1. A model where economic development is based on
the idea of successive stages of development.
2. Rostow identified 5 stages of growth:
 The traditional society
 The pre-conditions for take-off
 The take-off
 The drive to maturity
 The age of high mass consumption

3. All advanced economies have passed the stage of

take-off into self sustaining growth
4. Developing countries are still in the traditional
society or the pre-conditions stage. Why?
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 Rostow – 5 Stages of
Growth

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 Rostow – Stages of Growth
1. Traditional Society
 Characterised by
 subsistence economy
– output not traded or
recorded
 existence of barter
 high levels of
agriculture and labour
Village in Lesotho. 86% of the resident workforce in intensive agriculture
Lesotho is engaged in subsistence agriculture.
Copyright: Tracy Wade, http://www.sxc.hu/  Limited ability to
growth due to lack of
modern technology
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 Rostow – Stages of Growth
2. Pre-conditions:
 Development of mining
industries
 Increase in capital use in
agriculture – commercialized
& mechanized
 Necessity of external
funding
 Some growth in savings
The use of some capital equipment can help increase
productivity and generate small surpluses which can be and investment
traded.
Copyright: Tim & Annette, http://www.sxc.hu

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 Rostow – Stages of Growth
3. Take off:
 Increasing
industrialisation
 Further growth in
savings and
investment –
Productive investment
rises from 5%-10% of
national income
At this stage, industrial growth may be linked to
 Some regional growth
primary industries. The level of technology required
will be low.  Number employed in
Copyright: Ramon Venne, http://www.sxc.hu agriculture declines

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 Rostow – Stages of Growth
4.Drive to Maturity:
 Growth becomes self-
sustaining – wealth
generation enables
further investment in
value adding industry
and development
 Industry more
As the economy matures, technology plays an
increasing role in developing high value added diversified
products.
Copyright: Joao de Freitas, http://www.sxc.hu  Increase in levels of
technology utilised

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 Rostow – Stages of Growth
5. High mass consumption
 High output levels
 Expansion of consumption level beyond
basic food, shelter, clothing - consumption
of durables consumers' goods & services
 High proportion of employment in service
sector
 National pursuit of external power &
influence - increased allocation to military
& foreign policy
 Mature economy becomes "Welfare state"
- government use power to redistribute
Service industry dominates the economy – banking,
insurance, finance, marketing, entertainment, leisure income through progressive taxation -
and so on. increase social security, shorten working
Copyright: Elliott Tompkins, http://www.sxc.hu days (more leisure).

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 The Harrod-Domar Model -
Simplified Version

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 The Harrod-Domar Model -
Simplified Version

World Bank Data : https://goo.gl/ivuK8W

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 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

• But there is now growing evidence of “per capita
income convergence,” weighting changes in per
capita income by population size

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 Criticisms of the Stages Model
• Low level of new capital formation in most
poor countries.
– Create “savings gap” – if insufficient saving &
investment, poor countries would seek for
foreign aid & private foreign investment.
• Necessary versus sufficient conditions
– Saving and investment is not necessary
condition to accelerate growth rate, but rather it
is not sufficient condition. (Other factors need to
consider)
– For example: Marshall Plan – US Aid to the
Western Europe after WW2 - Why? (let watch
this: https://goo.gl/d1Srhq)
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 1.3 Structural-Change Models
• Focuses on the mechanism of
transformation of domestic economic
structures from traditional subsistence level
agriculture to modern, urbanized & diverse
manufacturing and services industry.
• The Lewis two-sector model
– 1st sector – traditional, overpopulated, rural
subsistence with zero MPL (Labor surplus)
– 2nd sector – high productivity modern, urban
industrial sector
– Focus on the process of labor transfer and
growth of output & employment in the modern
sector.
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Figure 1.1 The
Lewis Model of
Modern-Sector
Growth in a Two-
Sector Surplus-
Labor Economy

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 Criticisms of the Lewis Model
4 Assumptions
• 1st – The rate of labor transfer and
employment creation in the modern sector
is proportional to the rate of modern sector
capital accumulation.
• The faster the rate of capital accumulation,
the higher the growth rate of the modern
sector and the faster the rate of new job
creation.
• Counter argument – If the capitalist
reinvested profits into more sophisticated
labor-saving equipment rather than taking
more workers, no new job creation
happens.
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 Criticisms of the Lewis Model

• 2nd - Surplus labor in rural areas and full

employment in the urban areas.
• Counter argument – Development
economists today agree that Lewis’s
assumption of rural labor surplus is not
valid. Contemporary research shows that
there is little labor surplus in rural location
due to seasonal & geographic exceptions.

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 Criticisms of the Lewis Model
• 3rd – A competitive modern-sector labor
market that guarantees the continued
existence of constant real urban wages up
to the point where the supply of rural
surplus labor is exhausted.
• Counter arguments – Institutional factors
such as union bargaining power, civil service
wage scales and MNC hiring practices tend
to negate competitive forces in modern-
sector labor market in developing countries.

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 Criticisms of the Lewis Model

• 4th - Assumption of diminishing returns in

modern industrial sector.
• Counter argument – Yet there is much
evidence that increasing returns prevail in
that sector.

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 1.4 The International-
Dependence Revolution
• It attributes the existence and continuance of
underdevelopment – (persistent low of living in conjunction
of absolute poverty, low economic growth rates, low
consumption level, poor health services, dependence on
foreign economies)
• Due to the historical evolution of a highly unequal
international capitalist system of rich-poor country
relationship
• Center vs Periphery relationship.
• Existence of small elite group with power, who serve for
international special interest power groups – MNCs, national
bilateral aid agencies & multilateral assistance organization
(IMF / World Bank)
• Underdevelopment is seen as an externally induced
phenomenon – in contrast to linear stage of growth &
structural change theories stress on internal constraints.
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 The Neoclassical Dependence
Model
• 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
– Criticisms and limitations
– Does little to show how to achieve development in a
positive sense; accumulating counterexamples

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 The False Paradigm Model

• 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
– Criticisms and limitations
– Does little to show how to achieve development in a
positive sense; accumulating counterexamples

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 The Dualistic-Development
Thesis
• 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
– Criticisms and limitations
– Does little to show how to achieve development in a
positive sense; accumulating counterexamples

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 1.5 The Neoclassical Counterrevolution:
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
– Traditional neoclassical growth theory - with diminishing
returns, cannot sustain growth by capital accumulation
alone

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 1.6 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

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 End to Topic 1

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 Concepts for Review

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

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 Concepts for Review (cont’d)

• Market-friendly approach • Production function

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

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 Implications of Rostow’s Theory
Development requires substantial investment in capital equipment (K); to
foster growth in developing nations, the right conditions for such investment
would have to be created i.e. the economy needs to have reached Stage 2.
For Rostow:
1. Savings and capital formation (accumulation) are central to the process of growth,
hence development.
2. The key to development is to mobilize savings to generate the investment to set
in train self generating economic growth.
3. Development can stall at Stage 3 for lack of savings. Suppose the deficiency in
savings is on the order of 15-20% of GDP. If S = 5% then foreign aid/loans of about
10-15% plugs this ‘savings gap’. Resultant investment means a move to Stage 4-
Drive to Maturity and self generating economic growth:
• i.e. virtuous cycles (e.g. Botswana) and not vicious cycles (e.g. Argentina).
• Once Stage 5(High Mass Consumption ) is achieved, this society continues
to have high consumption and maintains such by incentives to savings plus
additional key ingredients (good governance, property rights, human capital
and functioning institutions)

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 Limitations of Rostow’s Theory

1.Rostow's model is limited. The determinants of a country's stage of

economic development are usually seen in broader terms i.e. depend on:
(a) the quality and quantity of resources
(b) a country's technologies
(c) a countries institutional structures e.g. law of contract
2. Rostow explains the development experience of Western countries, well.
However, Rostow does not explain the experience of countries with
Different cultures and traditions e.g. Sub Sahara countries which have
experienced little economic development.

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 Criticisms:
1. Too simplistic
2. Necessity of a financial infrastructure to channel
any savings that are made into investment
3. Will such investment yield growth? Not necessarily
4. Need for other infrastructure – human resources
(education), roads, rail, communications
networks
5. Efficiency of use of investment – in productive
activities?
6. Rostow argued economies would learn from one
another and reduce the time taken to develop –
has this happened?
NASEEM
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reserved. 3-32
 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

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 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

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 Appendix 3.2 The Solow
Neoclassical Growth Model

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 Appendix 3.2 The Solow
Neoclassical Growth Model

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 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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 Appendix 3.3 Endogenous
Growth Theory
• Motivation for the new growth theory
• The Romer model

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