INTA 630: International Economic Development LECTURE 3: THEORIES OF DEVELOPMENT I THE CLASSIC THEORIES OF GROWTH AND DEVELOPMENT

LECTURE 3: THEORIES OF DEVELOPMENT I FOUR MAJOR CLASSIC THEORIES OF DEVELOPMENT I. Linear Stages of Growth Model II. Theories and Patterns of Structural Change III. International Dependence Revolution IV. Neoclassical Theory (Free Market Counterrevolution)

I. Linear Stages of Growth Models Rostow s Stages of Growth Theory Five Stages of Development : 1. Traditional Society 2. Pre-Conditions for Take-off into Self-Sustaining Growth 3. The Take-off (self-sustaining growth) 4. The Drive to Maturity 5. The Age of High Mass Consumption What was Rostow s Argument? 1. 2. 3. 4.

I. Linear Stages of Growth Models (cont d) Harrod-Domar Model of Growth Let: 1. k = K/Y or k = K/ Y where K = capital stock and Y = national income 2. s = S/Y where S = savings 3. I = K where I = investment and = change in 4. S = I so that investment must come out of savings Then substitute 1, 2, and 3 into 4: sy = K or sy = k Y Rearranging gives: Y/Y = s/k Conclusions? 1. Growth rate of GDP in a country is determined by the rate of savings (s) and the capital/output ratio (k). 2. The higher the percent of national income saved (s ) and/or the higher the output from a given stock of capital (k ), the faster the economy of a country will grow. 3. Main constraint to development is. 4. If a country cannot generate sufficient savings to achieve the target rate of growth, the savings gap can be filled through either. 5. Justifies massive transfers of capital and technical assistance from DCs to LDCs.

I. Linear Stages of Growth Models (cont d) Problems in Applying Linear Stages Models 1. The "tricks" of development did not always work. 2. Saving and investment are but not conditions for growth. 3. The importance of external, international influences.

II. Structural Change Theories Two Major Theories 1. Lewis Two-Sector Surplus Labor Theory 2. Patterns of Development Theory (Chenery Model)

II. Structural Change Theories (cont d) Lewis Two-Sector Surplus Labor Theory - Focus on the structural transformation of a primarily subsistence economy with two sectors: (1) Traditional sector: - overpopulated, rural subsistence sector with MP L = 0 (2) High-productivity, modern, urban, industrial sector to which surplus rural labor is transferred - Focus on the process of labor transfer and growth of output and employment in the modern sector: labor transfer and employment growth from output growth speed of output growth determined by rate of industrial investment and capital accumulation in urban sector investments made possible by excess of urban sector profits over wages, assuming all such profits are re-invested level of wage in urban sector fixed and set at some premium over ave. wage level in traditional sector

The Lewis Model of Modern-Sector Growth in a Two-Sector Surplus-Labor Economy Total output D 1

The Lewis Model of Modern-Sector Growth in a Two-Sector Surplus-Labor Economy Profit D 1 Share of Total Output Paid to Labor

II. Structural Change Theories (cont d) - Criticisms of the Lewis Two-Sector Theory 1. Assumes labor is transferred and employment created as capital accumulates in modern sector. But what if profits NOT reinvested due to: - capital flight - re-investment in "labor-saving" rather than "labor-intensive" technology ("antidevelopmental" economic growth). The Lewis Model Modified by Labor-saving Capital Accumulation: Employment Implications 2. Assumes surplus labor in agriculture and full employment in urban areas. 3. Assumes a competitive modern-sector labor market. 4. Assumes diminishing returns in the modern industrial sector

II. Structural Change Theories (cont d) Patterns of Development Theory (Chenery Model) - Focus on the of economic, industrial, institutional change - Assumes that S and I necessary but not sufficient conditions for growth - Also necessary are changes in the economic structure which face constraints in LDCs - Differences in (domestic and international) account for differences in development levels among countries - International constraints most important since transition can occur faster with access to international sources of capital, technology, manufactured imports, etc.

II. Structural Change Theories (cont d) Patterns of Development Theory (Chenery Model)(cont d) - Chenery used time series and cross country models to identify characteristic features of the development process. - Identified five characteristic features (not necessarily stages) of the development process for countries that have developed: 1. Shift from agricultural to industrial production 2. Steady accumulation of physical and human K 3. Change in composition of consumer demand 4. Growth of cities and urban areas 5. Decline in family size and overall population growth

III. International-Dependence Revolution Three Types of Models in This Area 1. Neoclassical Dependence Models 2. The False Paradigm Model 3. Dualistic-Development Thesis

III. International-Dependence Revolution (cont d) Neoclassical Dependence Models - Outgrowth of thinking - Underdevelopment the result of dominance by and dependence on industrialized countries, international special interest groups (MNCs, foreign aid agencies, World Bank, and IMF) - Small, elite ruling class in LDCs perpetuates the dependence - A large part of underdeveloped world s continuing poverty due to the existence and policies of industrial countries - LDCs can only grow and develop as large countries grow - Thus, underdevelopment is an EXTERNALLY induced phenomenon - Revolutionary struggles or major restructuring of world capitalist system needed to free LDCs from economic control of DCs and elite oppressors.

III. International-Dependence Revolution (cont d) False-Paradigm Model - Underdevelopment the result of faulty or inappropriate advice and recommendations by well-meaning but often uniformed, biased, and ethno-centric international expert advisers from DCs - Advisers base their models and analysis on faulty assumptions more appropriate for DCs - Problem perpetuated by DC educational institutions - Domestic planners and policymakers trained in Western concepts

III. International-Dependence Revolution (cont d) Dualistic-Development Thesis - Views the world as composed of divergences between rich and poor nations and of rich and poor people at various levels - Four Key Arguments: 1. Different sets of conditions can coexist 2. Such coexistence is chronic 3. The discrepancies in superior and inferior conditions will increase over time 4. There is no from the rich to poor

III. International-Dependence Revolution (cont d) Weaknesses of International-Dependence Theories These theories call for fundamental, economic, political, and institutional reforms but demonstrate several weaknesses: 1. They offer little explanation of how countries initiate and sustain development 2. Actual experiences of LDCs pursuing revolutionary change to achieve development are mostly negative (e.g., Mexico, China, India, Cuba) 3. The logical conclusion of this theory is that LDCs should

IV. Neoclassical Theory of Development (Free Market Counterrevolution) Some Basic Neoclassical Theory Concepts - All countries have production possibilities frontiers (PPFs) Y The slope of the PPF increases from left to right. y y A To obtain a given amount of X ( X), larger and larger amounts of Y ( Y) must be given up. MRT increases along the PPF from left to right y B Note that the MRT at B > MRT at A x x x X

IV. Neoclassical Theory of Development (cont d) - Different Countries Have Different PPFs Y Nation A Y Nation B X Differences in shapes of PPFs arise from: 1. Different 2. The use different in production Assume: 1. Two factors of production: Labor (L) and Capital (K) 2. X is capital-intensive good and Y is labor-intensive good: (K/L) x > (K/L) y 3. Nation A is relatively capital abundant; Nation B is relatively labor abundant: (K/L) A > (K/L) B Thus: A will tend to produce relatively more X than Y B will tend to produce relatively more Y than X X

IV. Neoclassical Theory of Development (cont d) - Two Sources of Economic Growth in the Model: 1. Growth in factor endowments (K and L) - Balanced Growth (K and L grow at same rate) - Imbalanced Growth (only one of the two factors grows) 2. Technical progress (new technology) - This simply means K and L become more productive in the production of one or more outputs. - Many definitions and types of technical progress. - We will assume neutral technical change that increases the productivity of both capital and labor in the same proportion.

IV. Neoclassical Theory of Development (cont d) 1. Factor Growth: Three Cases (1) Balanced growth (both K and L grow at same rate) Note: Assuming a Constant Return to Scale (CRTS) production function means that if you double both K and L, you double output. But to get a proportionate increase in output, K and L must both increase in that same proportion. (Thus, for example, if you only double L, output increases by LESS than double.)

IV. Neoclassical Theory of Development (cont d) 1. Factor Growth (cont d) (2) Unbalanced Growth - L growth only PPF curve moves out more along A axis than along N axis (Why?) Why does PPF move out along N axis at all? (3) Unbalanced Growth - K growth only PPF curve moves out more along N axis than along A axis (Why?) Why does PPF move out along A axis at all?

IV. Neoclassical Theory of Development (cont d) Relationship between Factor Growth and Economic Growth Balanced Factor Growth When both L and K grow at same rate (CRTS), then ratio of capital to labor (K/L) and productivity of K and L remain the same. If dependency burden does not change, then real per capita income (Q/L) does not change. (Note that Q/L = 2Q/2L.) Unbalanced Factor Growth When only L grows, then K/L decreases and the relative productivity of L declines. Also, real per capita income declines because output increases by smaller proportion than L. (Note that if L doubles, Q will increase by LESS than double so Q/L declines.) When only K grows, then K/L increases and the relative productivity of K declines. Also, real per capita income increases because output increases while L does not increase. (Note if only K doubles, then output increases to some extent but L does not increase. So Q/L increases.)

IV. Neoclassical Theory of Development (cont d) 2. Technical Progress: Three Cases (1) Productivity of K and L increase proportionately in Production of both A and N (2) Productivity of K and L increase proportionately in Production of only A (3) Productivity of K and L increase proportionately in Production of only N

IV. Neoclassical Theory of Development (cont d) Relationship between Technical Progress and Economic Growth (1) All types of technical progress tend to increase a country s per capita income since L endowment does not change but output increases. With factor growth, only growth of K will increase per capita income. (That is, population growth only makes a country poorer.) (2) With a higher PPF curve and the same L and population, every person can be made better off than before technical progress occurs given an appropriate income redistribution policy. (3) The effects of trade on growth can change these conclusions. (We ll see this later in the semester.)

IV. Neoclassical Theory of Development Basic argument: Underdevelopment results from poor resource allocation due to: - - X X

IV. Neoclassical Theory of Development Economic efficiency and growth stimulated from: - allowing free markets to function - privatizing state-owned enterprises - promoting open markets and export expansion - opening doors to foreign investment - eliminating gov't. regulations and pricing policies that distort factor, product, and financial markets DCs are not the cause of LDC problems - Basic problem: intervention of their own governments, corruption, lack of economic incentives Development is a simple matter of promoting free markets, laissez-faire economics with a government that allows markets to work Based on Harrod-Domar and Solow models - Liberalization of markets draws foreign investment and increases rate of capital accumulation - Foreign investment works like an increase in savings in H-D model

IV. Neoclassical Theory of Development Four Problems with the Neoclassical Theory 1. Primary problem: 2. Problem of market failures ignored - widespread externalities - barriers to economies of scale - market power - multinational corporations - subsistence producers (not participating in market economy) - lack of information - profit maximization may be low priority 3. Much growth not accounted for by growth in labor or capital stock - The Solow Residual: Increases in GNP not accounted for by adjustments in L or K stock attributed to some "residual. The residual is the result of unexplained exogenous process of technological progress - Large % of historical growth not explained - Determinants of the technical progress undefined - Large differences in residuals across countries 4. Cannot explain anomalous flows of capital from POOR to RICH countries